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Mad Catz Interactive, Inc. (NYSEMKT:MCZ)

F3Q2014 Earnings Call

February 6, 2014 5:00 PM ET

Executives

Norberto Aja – Investor Relations

Darren Richardson – President and Chief Executive Officer

Karen McGinnis – Chief Financial Officer

Analysts

Justin Ruiss – Sidoti & Company

Elliot Gerstenhaber – Private Investor

Stanley Trilling – Credit Suisse

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Mad Catz Interactive 2014 Third Quarter Results Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded today, Thursday, February 6, 2014.

I would now like to turn the conference over to Norberto Aja, Investor Relations. Please go ahead, sir.

Norberto Aja

Thank you, operator. Good afternoon everyone and welcome to Mad Catz’s fiscal 2014 third quarter results conference call. With me on the call today are Darren Richardson, Mad Catz’s President and Chief Executive Officer and Karen McGinnis, Mad Catz’s Chief Financial Officer. Darren will provide an overview of the results and the principal drivers behind them. Afterwards, Karen will review the financial results in greater detail, before turning the call back to Darren for some closing remarks.

But before we begin, let me just take a few minutes to read the Safe Harbor language in today’s discussion regarding 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 any 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, should, plan, goal, believe and other words in terms of similar meaning in connection with any discussion of future operating or financial performance.

Among the factors that could cause actual future 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, availability of capital under our credit facility, commercial acceptance of new in-home gaming consoles, the ability to successfully market both new and existing products domestically as well as internationally, difficulties or delays in manufacturing, and anticipated product delays or a downturn in the market or industry as a whole. 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 on February 6, 2014 include non-GAAP financial measures within the meaning of the SEC Regulation G. When required, a reconciliation of all non-GAAP financial measures to the most directly comparable measure calculated and presented in accordance with GAAP can be found in today’s press release.

With that, I would now like to introduce Darren Richardson, President and CEO of Mad Catz. Please go ahead, Darren.

Darren Richardson

Thanks Norberto and good afternoon everyone. We appreciate you joining us on the call today to review our fiscal 2014 third quarter financial results. At Mad Catz, we’re focused on developing products for passionate gamers and when we say that, we mean people who play games as part of their everyday lifestyle and not just when there is nothing interesting to watch on TV. As a result, we’re platform agnostic and we develop products for gamers wherever they are looking to engage. And today, that means doing products for consoles, PCs and increasingly for mobile.

With that in mind, I’d like to take a few minutes to review the industry as we see it today and more importantly, what we think it would look like in the not too distant future.

The 2013 holiday quarter was certainly pivotal for the games industry with the launch of two new game consoles, marking the inflexion point in the console transition. Even more exciting for our longer term outlook, sales to date of the new consoles have set new adoption records and exceeded the already lofty expectations. Although the sales of accessory products for new consoles typically lag the launch, we believe the new consoles open up opportunities for innovation that will kickstart another multiyear period of excitement and revenue growth for console products as a whole.

As another industry participants have noted, we saw sales of legacy console products decline at a faster than anticipated pace and we took action to reduce inventory levels of legacy products during the holiday season. However, we believe both console manufacturers are committed to supporting the sale of legacy – our platforms and we expect sales of products for legacy platforms will continue for years to come.

In short, our console business is in a tough place today, but we believe it’s poised to rebound and we view the console business as a short-term challenge yet a major growth opportunity beginning in the second quarter of fiscal 2015.

The PC games market continues to attract hardcore gamers and counter to the PC industry as a whole, continues its path of steady growth. We added our first PC products to our sales mix a few years ago and products for the PC gaming segment have steadily grown to account to 40% of our sales and include our R.A.T. mice, S.T.R.I.K.E. keyboards, F.R.E.Q. and TRITTON headsets and Saitek flight simulation products. The excitement around the upcoming launches of Steam Machines, innovative game consoles designed to bring PC gaming to the living room as well as new game streaming technologies like Nvidia's GRID create additional growth drivers for PC gaming and more directly additional opportunities for further innovation and sales growth for Mad Catz.

Lastly, the single largest opportunity in consumer products today is in the mobile space. Smart devices are rapidly establishing themselves as very capable platforms for all forms of entertainment including music, movies, books, social media and games. It’s also important to note the relative size of the market. The Xbox 360 has sold over 80 million units in the seven years since it launched, a considerable accomplishment for a gaming console, but there were over 1.2 billion smartphones and tablets sold in 2013 alone and over 2 billion units forecasted in 2017.

We are also excited about the recent announcement that iOS 7, Apple’s new operating system for iPhones and iPads includes controller support. More recently, Google launched the Kit Kat operating system for Android which adds Bluetooth low energy support for gaming controllers, mice and keyboards, effectively our GameSmart products. While we don’t see touchscreen games being replaced anytime soon, we do expect more games to include controller support and we expect this trend to open up new opportunities including the entire living room gaming experience on smart device.

Almost two years ago, we embarked on our GameSmart initiative designed to directly address this opportunity with a line of gaming products for smart devices including controllers, mice, keyboards and headsets as well as M.O.J.O., our micro console for Android. We’ve already made the investment to build out this suite of products and the good news is we’re first to market. We believe this space is going to be a slowburn as the software evolves to take advantage of the performance of leading edge hardware. Short term, the mobile is a positioning exercise for an opportunity in its infancy but we believe it has enormous potential in the medium to long term.

Console transitions are tough, but we believe we are pursuing the correct strategy. Our focus and our goal is to bring to market a compelling consumer offering on a global basis. We believe that Mad Catz can succeed if we build on our strengths to pursue targeted segments within the games industry and leverage our strong and deep distribution footprint to deliver products with the right design and features that are central to the passion that gamers experience.

With that, I would now like to turn the call over to Karen to provide some additional color on our results. Karen?

Karen McGinnis

Thanks Darren. I’ll begin my comments with a review of our income statement. Net sales for the third quarter were $32.9 million, which represents a 27% decline from the third quarter last year. Consistent with last quarter, we experienced a decline in net sales across all regions and product categories as demand decreased ahead of the late November launch of the Xbox One and PlayStation 4 gaming consoles. While the consoles sold well during the quarter, sales of accessories for new consoles are typically delayed until after the consumer digests the initial purchase of the console and related video games. As Darren noted, this decrease in demand was consistent with the rest of the industry.

The decline in net sales remained more pronounced in North America where a greater percentage of our products center around console gaming compared to Europe where a greater percentage are for the PC and Mac. As a result, global sales in our PC and Mac category were flat this quarter compared to the prior year. As with the first half of the year, the gaming console transition had the largest effect on sales of our higher priced TRITTON auto products as consumers shifted their purchases towards lower priced products such as our Kunai range of headsets. This resulted in a 30% decline in audio product sales from the prior year, accounting for approximately 16% of the 27% decline in net sales during the quarter.

Additionally, we experienced an 83% decline in the controllers category due to sales of legacy controllers during the third quarter last year that did not repeat this year. We also experienced a 52% decline in accessory sales as a result of decreased demand for ancillary products such as cables and video adapters used specifically for legacy gaming consoles. Sales of our Saitek flight simulation controllers grew 4% over the prior year and we launched our Killer Instinct FightStick for Xbox One during the quarter, both of which helped to partially offset the softness in the sales of legacy platform specialty controllers. As a result, we experienced a 13% year-over-year decline in the specialty controllers category.

Looking at the results by geography, net sales in Europe declined 9% to $21 million and represented 64% of total net sales in the quarter compared to 52% a year ago. The decline in Europe was driven primarily by a decrease in sales of audio products for legacy consoles, partially offset by growth in sales of our R.A.T. gaming mice and keyboard as well as our Saitek flight simulation products. The increase in R.A.T. gaming mice was due partially to a large customer order that occurred in September last year versus October this year, due to changes in the shipping term to that particular customer.

Net sales in North America declined 48% to $9.9 million due to weakness in legacy console related sales and a significant reduction in product placements across some key U.S. accounts. North America net sales represented 30% of total net sales in the third quarter compared to 42% a year ago. As we bring to market new products and work through the new console cycle, we expect sales in North America to regain momentum and represent a greater percentage of overall sales.

Net sales to Asia Pacific declined 27% to $2 million and represented 6% of our total net sales in the third quarter, the same percentage as a year ago. Consistent with our other geographies, weakness in the legacy console related sales was the primary factor behind softness in Asia Pacific. We expect sales in this region to grow as our presence and focus increases.

As a result of the decrease in overall net sales and to a lesser extent a gross margin decline, gross profit for the third quarter decreased 39% from the prior year third quarter. Gross margin fell to 24% from 29% in the prior year third quarter. The decrease in gross margin was due primarily to an increase in distribution center costs, returns and allowances and inventory write downs as a percentage of net sales, offset partially by a decrease in royalties and licenses as a percentage of net sales. The increase in inventory writedowns was driven primarily by a $1.5 million write down of raw materials specifically related to products for legacy gaming consoles. Furthermore, we offered some closeout pricing on some of our older, slower moving inventory during the holiday season. Overall, we expect gross margin for the full year of fiscal 2014 to be lower than fiscal 2013.

Total operating expenses were $7 million, down 20% from the third quarter last year. The decrease was driven by declines in variable sales and marketing expenses, due primarily to the decrease in net sales, a slight decrease in research and development spending and a decrease in general and administrative expenses, driven mostly by a decrease in bonus expense. We are making a concerted effort to reduce overall operating expenses across the board going forward and for the full fiscal year, we expect operating expenses on an absolute dollar basis to be lower than fiscal 2013.

As a result, we recorded third quarter operating income of $900,000 compared to $4.1 million in the prior year third quarter. Other income and expense, which primarily represents interest expense on our outstanding debt, foreign currency exchange gains and losses and changes in the fair value of our warrant liability generated expense of $187,000 in the third quarter this year compared to income of $82,000 in the third quarter last year. This change was driven primarily by increases in expenses associated with the changes in the fair value of the warrant liability and foreign currency exchange losses.

Overall, we generated a net loss in the third quarter of $566,000 or a loss of $0.01 per share. This compared to net income of $3.1 million or $0.05 per share in the third quarter last year.

Moving on to our cash flow statement and balance sheet. Net cash used in operating activities year-to-date was $3.4 million which primarily reflects the net loss for the period before non-cash items, offset partially by a decrease in inventory of $3.8 million. Our DSOs and inventory turns continued to improve as our gross DSOs were 48 days this quarter compared to 66 days last quarter and 63 days in the third quarter a year ago. Our inventory turns on a trailing four quarter basis were 2.9 times this quarter compared to 2.7 times last quarter and 2.8 times in the third quarter a year ago. As of December 31, 2013, we had cash balance of $3.5 million and borrowings under our credit facility of $14.6 million. As a result, we ended the quarter with a net position of bank loan less cash of $11.1 million. This compared to 13.5 million as of December 31, 2012 and 11.4 million as of September 30, 2013. As of December 31, 2013, we were in compliance with all of our financial covenants.

Overall, this has been a challenging year due to the impact of the gaming console transition, yet we have remained focused on effectively managing our overall liquidity position by reducing inventory levels and expenses and managing our accounts receivable collection efforts. We are making progress and remain confident that our business strategy, product offerings and financial position will be primed to deliver improved results on the backside of the console transition and continued growth of the mobile gaming market.

With that, I would now like to turn the call back to Darren for a review of recent developments and closing remarks, after which we will open the call for questions. Darren?

Darren Richardson

Thanks Karen. The recent announcements from Apple and Google introducing support for controllers and other gaming peripherals establishes the infrastructure to support a core gaming experience on mobile. And by core gaming experience I’m referring to mobile gaming on a big screen in the living room rather than on a touch screen. Our GameSmart initiative delivers an ecosystem of gaming controllers, mice, keyboards and headsets to complement the new operating systems. However, controller supported games on mobile devices remain an emerging category and it’s going to take some time for game developers to leverage the full potential of the new operating system, add full controller compatibility and allow for the general distribution of compatible gaming accessories. That being said, we believe it will happen this year.

While there is little doubt M.O.J.O. is the centerpiece of our GameSmart initiative, it’s important to see the benefit of the entire ecosystem of GameSmart products when thinking about the scope of the opportunity. With M.O.J.O. we’re taking a cautious approach and targeting tech enthusiasts rather than the mass market customer. With just over 1000 units shipped for the holiday. We’re also excited about the upcoming launch of the multi-award winning game Titanfall. Titanfall is one of the most anticipated game launches and in the next few weeks we’ll be shipping our range of Titanfall licensed mice, keyboards, headsets and gaming surfaces to coincide with the release of the game in March.

In terms of outlook for the current quarter, we are experiencing another challenging quarter on the top line and the potential for ongoing margin pressure as we work through retail channel exposures as a result of the console transition. We remain focused on working capital management and OpEx reduction and look forward to return to sales growth and profitability in fiscal 2015.

Before we move to Q&A, I wanted to take a moment to thank our talented and dedicated team at Mad Catz who are responsible for moving us forward with our key initiatives. I’ll now turn the call back over to the operator so we can answer any questions. Operator?

Question-and-Answer Session

Operator

Thank you, Mr. Richardson. (Operator Instructions) Our first question is from the line of Justin Ruiss from Sidoti & Company. You may begin.

Justin Ruiss – Sidoti & Company

Hi Darren, hi Karen.

Karen McGinnis

Hi.

Darren Richardson

Hi Justin.

Justin Ruiss – Sidoti & Company

Just have a question. You mentioned that Apple and Google are – now have these two platforms that can support external controllers on there and that’s well and good. But what I want to know is there is a core market out there that you spoke of that all these smartphone users are out there and many of them could be – there could be an overlap of core gamers and then just regular casual players out there. Do you think or at least maybe if this is maybe you could say if it’s true or not, but do you think the core gamers would respond well to maybe publishers putting their logos, putting their weight behind mobile games? And if so, do you see publishers doing that? At least from the mobile games that I’m looking at, or that I see people playing, there is never really a big publisher put on to there; it’s always more a focus of like the developer. So do you think anything like that could be the case in the coming future?

Darren Richardson

Yeah absolutely. And I think one of the things that the new operating systems enable is a much easier way to port content and also have content that is an enhancement to other mainstream games. And so this whole idea of continuous gaming where you can actually have parts of the game that go off on to other platforms and come back and still play a role within the major game even though it’s not a continuation of the game in and of itself. And I think if you look at some of the discussion that’s happening in and around some of the major publishers, I think this is an area that you’ll see a lot of activity in the next year.

And for all those key publishers, they are in the same situation we’re in where they are looking at following gamers to where gamers go. And I think mobile has always been an area for social gaming and sort of more casual gaming, but that doesn’t mean that hardcore gamers don’t also play mobile games when they are out and a bout. And I think when you look at the processing power that’s now available on mobile products some of the new software development tools that are coming on stream for mobile game development and some of the statements made by some of the leading software publishers in recent times, I think you’re definitely going to see a lot more AAA content make its way across multiple different platforms including mobile.

Justin Ruiss – Sidoti & Company

Gotcha. I know you mentioned Titanfall, which is great. It’s excellent that you’ll be shipping all that stuff very soon. Just kind of looking at the pipeline of games that are out – that are maybe coming out in March, or somewhere down the line, maybe in the next fall, I mean are you seeing a lot of – or are you hearing kind of the hoof beats of a lot more of these multiplayer games coming out anytime soon? And are there many opportunities that you could kind of exploit going forward?

Darren Richardson

No question, and when you come through to holiday next year, you’ll see a lot of additional support for the nextgen consoles. One of the challenges that publishers have on nextgen is it’s a small installed base right out of the gate where – I mean the adoption of the new consoles has been phenomenal but it still is only in the sort of 4 million units shipped today and escalating at a very rapid rate. But when you compare that to the installed base, just of Xbox 360 of 80 million units already out there in the marketplace, the addressable market in the early stage of the console launch is fairly small. So you typically see a small number of titles. That said, a title like Titanfall which has so much depth I think is going to be a title that continues to sell strongly right through the course of the year and into holiday and will probably be one of a handful of titles, a must have titles whenever you buy a new system. Most people when they purchase will buy that game plus Forza and a couple of other games that are out there that are on the must have list. And so – buy by the time you get to holiday next year, you’ll start to see a large number of software titles for the new consoles and that’s going to be great for everybody.

Justin Ruiss – Sidoti & Company

Gotcha. Then lastly, I mean kind of just forgive me for maybe outing the plan here, but if the consoles – if you’re talking about a 4 million installed base on maybe each of the new consoles that have both come out now, looking at your alternatives, I mean are you throwing a lot of chips into the PC arena at this point? I know Europe is the biggest PC kind of market that you’re going for, but are you tracking how well PC sales are doing or PC builds are doing in North America and is that something that possibly you’re going to have to start pushing more of your chips into that, maybe in the short term?

Darren Richardson

Yeah, and we’ve been focusing on that over the last couple of years and that’s why we’re really pleased that we’ve got out PC sales up to about 40% of the business, which is a considerable improvement given the bulk of those sales have been organically grown products like the R.A.T. and the S.T.R.I.K.E. keyboards and the F.R.E.Q.s and the like. And if you look at the product releases just over the last six months, it seems like having TRITTON products that are specific to PC where historically TRITTON has been much more of a console brand is important. There is a couple of other things happening on the PC front though as well with the Steam machines expected to start coming out this year that allows you to bring PC games into the living room which is, the PC gaming arena has historically been much more of a – something for the desk and on the computer and bringing that content across to the living room opens up a lot of scope for innovation of new ways to play.

Likewise, things like Nvidia’s Grid that allows you to stream PC games from a PC to a device like our M.O.J.O. for example also opens up different use applications and takes that same high end, hardcore content from your PC which is typically not in the living room into the living room for a living room experience. And once you’re in the living room, your interface products have totally different requirements than sitting at a desk where the mouse and keyboard is the preferred way to play. And so there is a lot of scope for innovation there and what’s happening on that front is really exciting. So if you think about PC being really the one end of the spectrum with the hardest core gamers, the PC market is going to start to make some incursions down into the console, or the space that traditionally the console space, the living room. And then if you look at mobile, which traditionally has been much more casual, mobile is starting to make incursions up into the living room as well with a much more core gaming experience. So this year, I think we’re going to see some of the most interesting new concepts that really start to open up great business opportunities for us because in all honesty the touch screen has been a phenomenal way to play mobile games. But for a company like us, the touch screen offers very, very, very little opportunity to do products that help anybody play games better or to actually drive revenue. And so once you take that and have a living room experience with that, either on dedicated products like the M.O.J.O. or on existing tablets and smartphones that can be docked, linked to a smart – to a TV and played in the living room. You still then need to have controllers to be able to use that content once it’s out on a big screen from the lounge chair.

So I think it’s going to be a really exciting year, a lot of scope for opportunity and a lot of innovation in the terms of options for people to play games and the kind of games that are coming – that are going to come out. So I think it’s going to be a very, very exciting year.

Justin Ruiss – Sidoti & Company

Well very good. Well best of luck to you and take care.

Darren Richardson

Thanks.

Karen McGinnis

Thanks Justin.

Operator

Our next question is from the line of Elliot Gerstenhaber, private investor. Please go ahead.

Elliot Gerstenhaber – Private Investor

Yeah hi Karen and Darren.

Karen McGinnis

Hi Elliot.

Darren Richardson

Hi Elliot.

Elliot Gerstenhaber – Private Investor

Obviously the results were not what I would like but following what you had said, they seem to fall within the overall purview of people within the industry. So taken in that light, they are not as bad as they might first appear. I am curious about a couple of things that you said though. Obviously the sales in North America has simply fallen off the board and there are only a limited number of outlets that sell the product, with I think Amazon being the lead. What can you do in the coming year to improve that so that the Mad Catz products are carried by more of the limited number of people who are marketing it?

Darren Richardson

Yeah and the different retail concentration within North America than what you see in Europe where you just have a larger number of smaller retail players. So it does create a lot more challenges in terms of going to market. One of the things that we’ve been focused on as a company for a long time is making sure that when we do sell product, we can actually drive the appropriate returns and profitability from those products and not just drive sales. And so to the extent that we’ve got products or product placements that are not making money and not generating revenue, our decisions have been to discontinue those products and invest in supporting products that are actually growing those revenues. Positively I think if you see what happened to retail this holiday for almost all different segments, not just consumer electronics but even out into clothing and categories that previously were immune to ecommerce, you’re seeing quite a massive shift towards ecommerce. For us, our product line these days is tooled very much to be a very successful ecommerce product line because they are products that appeal to passionate consumers who go out and they do the research, they find the product that they want and then they buy that product at the best price and service that they can get. And so as a result, we’re seeing ecommerce has an increasingly significant channel for our products.

Now that doesn’t mean that therefore we don’t want to have bricks and mortar and we’ve got a couple of long-term key retail partners that we support. They support us and we’re very active trying to build business and growth that business. But to the extent that the business is tied heavily to console, this holiday there is just no sidestepping the fact that the console business is a very difficult one. We expected that, it is that and as the console business bounces back, you will see a lot of the bricks and mortar sales bounce back along with that. And so I think the channel strategy is a good strategy. The U.S. market has its own challenges that are unique to the U.S. simply because some of the major retailers in the U.S. have some very serious challenges that they are working through themselves. And so I think we’re making decisions that are in the best long-term interests of driving a profitable business.

Elliot Gerstenhaber – Private Investor

Darren, is it possible that future U.S. sales will pale in comparison to Europe and APAC?

Darren Richardson

U.S. sales currently are paling in comparison to Europe and APAC is coming on incredibly strong. So that said, we have not given up on U.S. sales. We continue to push hard on U.S. sales and I think with the bounce back of consoles where the U.S. games market is a predominately console games market as opposed to a PC games market, so it’s been much more impacted by the console transition than Europe where a lot of the markets, for example, Germany are predominately PC markets. So the rebound of the console business will also have an effect or rebounding the U.S. business.

Elliot Gerstenhaber – Private Investor

Okay. And with regard to the M.O.J.O., if I read what you said correctly, it was almost as if you were doing a soft entry of the M.O.J.O. product if sales were up 1000 units. And…

Darren Richardson

Correct, yes.

Elliot Gerstenhaber – Private Investor

Excuse me?

Darren Richardson

That’s absolutely the intent and that’s what we were talking about before where we’re going out targeting tech enthusiasts at this stage because I think that’s the community that sees the real value of M.O.J.O.

Elliot Gerstenhaber – Private Investor

Okay. And do you have a sense of how many of those 1000 units that were sold to retailer, I mean how many of those were actually sold? Sold to combined probably.

Darren Richardson

Little bit harder to get that because it predominately goes through ecommerce; it’s almost an exclusive ecommerce channel, although we did have a very nice in store display in a large French retailer. But I mean with – we only had just over 1000 units available to us to ship and we shipped all of the units that we had. And we’ve got a fairly conservative flow of product coming in and we’re making great strides in terms of increasing the number of games and the functionality of M.O.J.O. And as that games and functionality start to expand, we’ll see demand expand along with it but what we didn’t want to do is go into a very heavy inventory push in and then have the product struggle at retail. We want to build demand which will take time and as demand builds across time, as the software content and the games evolve across time, which we believe you’re going to see that this year, then we’ll start to wind up the wick and get more distribution. But the product itself is a great product, it just needs some more content which is not within our control to have the product reach its full capability.

Elliot Gerstenhaber – Private Investor

Great. And I noticed on the Mad Catz site that you have M.O.J.O. sales and then it’s almost an explanation of how to use the M.O.J.O. And so I want to complement you on that because you must have been getting some feedback that it’s not as easy just to plug it in and several of the reviewers seem to feel that there was – that it was a great product but that you had to pool around with it a bit to really get it to perform like they thought it would. Is that a fair assessment?

Darren Richardson

Absolutely. And in fact, for people who are Android enthusiasts, they don’t need very much help because they know all of that stuff already and immediately in and doing all those sort of stuff that they want to do on it to extract the performance out of it. But for the average consumer, you do have to go through some steps to get the setup to where you can really get the benefit out of it. But I think for people who actually want to explore new technology and high performance technology on Android, it’s a great product.

Elliot Gerstenhaber – Private Investor

All right. But the bottom line is it needs more games and content; without that, the other features don’t seem to be enough of a driver to sell these in large numbers. Fair enough?

Darren Richardson

Yeah, absolutely and the games and content are definitely going to be coming this year, so it’s a matter of time. For me, I use M.O.J.O. most days as one of my core entertainment options, accessing the Internet on it. It’s the best Internet browsing experience you’ll find on any device that’s a multimedia device that connects to your TV and I have used pretty much everything that’s out there from the Apple TV, the Roku and all those kind of things. M.O.J.O., because of the interface and the controller gives you an Internet experience that is second to none. So it’s got some phenomenal capability in terms of tapping that. But at the end of the day, we think its real home is going to be as a great way to play great Android games in the not too distant future.

Elliot Gerstenhaber – Private Investor

Well as you said in your remarks, the number of Android phones sold is just staggering. And for what you just said, even without the ability to play as many games as you might like, where – why is there not a way to get across to the public how valuable it is and not – the games are just the icing on the cake but that for the value received it’s a product that they should have even without the games?

Darren Richardson

Well if you already have a smartphone, you can use any of the GameSmart products like the controller, the R.A.T.M, the S.T.R.I.K.E.M keyboard to do the same thing as long as you dock your phone to a large screen TV, so. And that’s one of the things that we keep coming back to. M.O.J.O. is a really interesting technology piece to basically put a piece of hardware out there that’s super high performance. And if you look at any of the review sites that clock performance of Android hardware, M.O.J.O. comes in at the top of the table on most of those, in the top 2 or 3 devices available in the marketplace today. So there is no question about performance on M.O.J.O. But the real opportunity and it’s an opportunity that’s a real one today is to be able to get that same kind of big screen living room experience using your existing tablet or smartphone and using one of the actual GameSmart products. And so that I think is the real big opportunity with that couple of billion dollar smartphone installed base that’s out there that’s growing rapidly. And that’s where a lot of our focus is going to be.

Elliot Gerstenhaber – Private Investor

All right. Well thank you for time and both I appreciate how much you are focused on cash management to get us through this more awkward period till there are better sales.

Darren Richardson

Okay, thanks Elliot.

Karen McGinnis

Thank you.

Operator

Our next question is from the line of Edward Erikson from Mad Catz. Please go ahead.

Unidentified Analyst

Yeah hi Darren. I’m an individual investor in Mad Catz all for about five or six years and I just have a couple of questions. One, could you let us know how are the pre-orders, how many pre-orders are you getting for the Titanfall products and the Racing Wheel and also Killer Instinct? I mean Killer Instinct was selling like crazy and then boom, I guess you ran out of product which leads to the second question. Do you guys have enough resources to produce these things in mass? I mean Killer Instinct, the arcade stick was selling like crazy. And also, are you going to be producing headsets for the Xbox One?

Darren Richardson

Okay, let me take that in order. In terms of the pre-orders I couldn’t even tell you the number off the top of my head, but all of the attach rates of the new consoles are relatively low simply because by the time you buy a $500 console and then you buy three games, you’re into about $800 before you leave the store. And so next when it comes to okay, getting a couple of $100 arcade stick plus the headsets, the quantities are small when it comes to the opportunity on those kind of products. Now in terms of the resource to do those products, there is absolutely no resource constraint in being able to do those products. Killer Instinct sticks have been coming in and going out. We’re running inventory on a fairly lean basis across the board. But on Killer Instinct when you’re looking at products for new product launches, it takes a while to ramp up production. And when you get a little window there, where demand outstrips production, you go into back order. But if you look at it, we’ve been in and out of back order on those products for a little while. And that’s a good news story at the end of the day. But all that said, the volume of all of the new platform products has not been that material given where the whole rest of the business is at and what we’re still doing on PlayStation 3 and Xbox 360. And so it’s interesting, it’s exciting as the year unfolds, it’s going to be great, but they are still quite small numbers compared to what we’re still doing on the legacy platforms. And the last question was on Xbox One headsets, frankly, we want to do headsets on all platforms. We don’t have Xbox One headsets at the moment; we do have PlayStation 4 headsets that are shipping in the market. But ultimately we want to support all platforms that are out there because that’s what we do as a business. So we’ve got some Xbox One products that have shipped, we’ve got additional Xbox products that are coming down the pipeline. And as we have products to announce, then we’ll do those announcements.

Unidentified Analyst

One final thing, thank you for the answer. I’m curious though, if you don’t know how many pre-orders you have, how do you know how many of these items to make?

Darren Richardson

Oh, we do as a company. I’m just telling you, me personally, I don’t. But what I did say is those products for the new consoles are quite low quantities until you get the installed base of those consoles and until people have digested the initial purchase of the actual console itself.

Unidentified Analyst

Okay, I understand that. But in closing, I’d just like to say, you’re the leader of the ship here and we’re watching this stock languish since the warhead days of two, three years ago. And I just think it would read confidence when folks call up and they ask you how many of a certain unit you were producing that the head of the ship would know. That’s all.

Darren Richardson

Okay.

Unidentified Analyst

Okay?

Darren Richardson

Okay, thank you.

Unidentified Analyst

You’re welcome.

Operator

Our next question is from the line of Stephen McNeil with Wedbush Securities.

Unidentified Analyst

Good afternoon guys.

Darren Richardson

Good afternoon Stephen.

Unidentified Analyst

My question was recently Amazon expressed interest in putting out a gaming console and I was wondering if you guys had received any interest or any preliminary discussions from a third party with the completion of your GameSmart initiative.

Darren Richardson

With GameSmart, we’ve actually reached out to pretty much everybody in the space. And we’ve had discussions with a host of people in the space. With most of the people we’ve had discussions with we also have NDAs in place and so it’s very hard for us to comment about anything in particular. But I’m sure as time goes on and those companies have announcements to make about what they are doing, they’ll actually make those announcements. But we’re focused on what we’re doing and with GameSmart, we’re trying to develop a series of products that work with as much as many different systems out there as possible. So there aren’t any systems that we would not want to support.

Unidentified Analyst

Great. And I certainly thing it is encouraging that companies such as Google and Amazon have explored entering the space, so I do think that is bullish going forward like you said. I appreciate you taking my question. Thank you.

Darren Richardson

You’re welcome.

Operator

(Operator Instructions) And our next question is from the line of Stanley Trilling from Credit Suisse. Please go ahead.

Stanley Trilling – Credit Suisse

Hi Darren and Karen. How much of the loss that you had incurred in the quarter was from inventory writedowns?

Karen McGinnis

Yeah hi Stan, it’s Karen. Specifically we had – I mean we had normal business writedowns, we had just as a business we’ll have inventory writedowns that are pretty normal in the business and particularly in the holiday quarter. But this quarter, we did have 1.5 million of what I would say is a little bit unusual writedown in that we wrote off some raw materials related to legacy product that we decided we weren’t going to continue to manufacture. And so that was – if you add back 1.5 million to gross margin into operating income that would take away that kind of unusual item.

Stanley Trilling – Credit Suisse

So that’s the difference between 24, 29 and 30?

Karen McGinnis

Yeah I think it was about 28.7 or so, it you added 1.5 to gross profit.

Stanley Trilling – Credit Suisse

Okay. And so far as the quality of the inventory that you have left, how much do you think you can unload on the market over the next six months?

Karen McGinnis

I think I – I mean Darren can speak too. We are really doing I believe a good job of managing the inventory and in the holiday season, we were aggressive in trying to move some of our slower moving inventory and taking reserves on things that were older inventory that we didn’t think was going to sell through. And so what we’re left with in inventory is inventory that we believe is our normal cycling inventory. So I feel good about it. We’re at – our turn’s right now at about 2.9. We will work over the next year to try to increase our inventory turns because I think optimally they’ll be closer to higher than 3, between 3 and 4. And so we’ll continue to work on that, but I feel good about where we sit right now with the inventory and the quality of the inventory.

Darren Richardson

And just as a follow up to that Stan, I think Q2 we saw a rapid slowdown in legacy console sales just like everybody else and so we went into a fairly aggressive promotional mode. So we did some – a lot of price promotions through the holiday and in a lot of cases it wasn’t a matter about getting rid of all the inventory and discontinuing product. But we did a very good job of bringing our inventory level down, bringing our channel inventory down in advance of January so that as we come through the retailers year end at the end of January, we have cleaned up most of the problems that are out there. And then the write down in Asia was really a decision to discontinue manufacturing some product to avoid manufacturing it, bringing it over and then sitting on it for a longer period of time and having it move through slowly. So it was really avoiding a longer term liquidation of the inventory. So we basically just took a call to write off materials and scale back on producing product that would be legacy console product.

Stanley Trilling – Credit Suisse

Well that was kind of a roundabout question because I really was more concerned about your liquidity needs and I thought that one, how are you addressing your liquidity needs – inventory sales, old inventory…

Darren Richardson

Yeah, and that’s a good question. If you look at last year, last year was pretty much a record year in terms of cash generated from operations; I’m talking about fiscal 2013 that ended in March. This year we’ve continued to do a great job on working capital reduction. So in the December quarter end, we had our net debt down at about $11 million plus some change which is one of the lowest points in the history of the company and a couple of million dollars than where we were this time last year. Now last year and Q4 the March quarter is where we collect the bulk of our cash from our Q3 sales. So when we came through Q4 last year ended up with net debt at the end of the year of 6 million. So to the extent that we’re ahead of where we were last year coming into Q4, we’re in a good place to get the net debt down to where it’s very much a nominal amount. And that’s an achievement that I don’t think we’ve received an awful lot of credit for because if you go back to October 2010, our total debt at that stage was $47 million. So we did a little capital raise a couple of years ago, 11 million, but the other $30 million in debt reduction has come from cash from operations.

And we still run a couple of million dollars a year in non-cash charges with amortization of brands and all those kind of things that really don’t have any cash impact. And if you back those non-cash charges out, the picture doesn’t look that bad. And even when it comes to the write-off of some of the materials, I mean the cash for those materials was expanded quite some time ago. So on a cash basis, I think we’ve done a very, very good job of managing working capital.

Stanley Trilling – Credit Suisse

Well that answer was just a little disingenuous, but the other part of the reduction in your debt was $14 million of converting your debt convertible to equity and so that’s $14 million. So…

Darren Richardson

Actually Stan, just a correction, we did not convert any debt to equity. We paid the $14 million back in cash.

Stanley Trilling – Credit Suisse

Okay. Yeah. But it was still elimination of debt through the raising – all right, minor point. My last question and this is what I’m most concerned about is the – I understand a significant part of the drop in U.S. sales has to do with PC versus mobile. But that being said, who the hell is marketing – who is in charge of marketing in the U.S. because that seems to me that half of the passionate gamers have…

Darren Richardson

Sorry, half of the – I just didn’t get the last part.

Karen McGinnis

We didn’t hear the last part.

Stanley Trilling – Credit Suisse

Because of the significant drop in U.S. sales, what happens to all of the passionate gamers in the U.S.?

Darren Richardson

Again, and that was a point I was making earlier, a large proportion of gaming in the U.S. is console based gaming, a larger proportion of gaming in Europe is PC-based gaming. And so as a result in a console transition, when the console market gets off with a transition the U.S. is always going to be more impacted than the European market. That’s just a matter of Europeans in a lot of different countries are still playing PC games as opposed to console games.

Karen McGinnis

And it’s not that the gamers in the U.S. go away, they just stopped purchasing for a while that transition goes on, or change their…

Stanley Trilling – Credit Suisse

Is that historically what it’s been?

Darren Richardson

Yes, absolutely. And then the other key is after you actually spend $500 for a console, a couple of hundred dollars for games, then fronting up after that to buy a couple of hundred dollar headsets for example which is about 50% of our business is a big ask. So there will be a lag before we get those headset sales starting to come in on the back of the console transition.

Stanley Trilling – Credit Suisse

Okay. By the way I want to congratulate on your acquisition of one of your new directors who – has unbelievable credentials. How do you intend to use him on the Board?

Darren Richardson

Well I think if you look at the Board as it sits today, we’ve got a very strong Board and I think John Nyholt brings a lot in terms of financial acumen. Scott brings a lot in terms of video gaming experience, but also sales and marketing experience having worked with tier 1 properties for the bulk of his career. And we’re at an inflexion point for the company here, we’re not through the trough, we’re looking at where to go. There is a lot of different moving parts and different opportunities within the video game space opening up the next 12 months and frankly having that depth of understanding of the industry on the Board I think is a good thing. A, is a sounding board, but please do also challenge management to make sure we are on our game and we are getting it done in terms of sales and marketing.

Stanley Trilling – Credit Suisse

Okay, thank you and one last thing. I have just one last thing for a second time. When do you think that you will have any visibility, because it’s been almost 18 months, 2 years’ worth of visibility has not been there for you guys?

Darren Richardson

Well I think if you follow anybody else in the videogame space right now and listen to any of the earnings from the large software companies, one of the things that you’ll take away is we’ve gone through a very disrupted period and a continuing disrupted period and a lot of the things that everybody knew to be true before are turning out not to be true this time around. And things are happening faster than people expect and that is the nature of the world we live in today. And so we just have to respond to that, we have to plan for it, and we have to respond to it. But in terms of telling you what’s going to happen in the next couple of months, it’s very, very hard for us to do that and very, very hard for major players in the industry to do that with so much change going on. But as we come through this year, one think I can tell you is the worst is very much behind us and now we have a lot of new opportunities starting to open up as the year goes on. And I think you’ll start to see a lot of excitement in and around games and returning to games because if you take games in its totality, games are actually doing quite fine; it’s just all the different segments have been disrupted with mobile, where frankly for us, mobile – everyone that starts playing mobile games doesn’t need one of our products. And so I think we’ve done a good job of positioning ourselves to be in the right place and now it’s a matter of letting the year roll on and extracting the best we can out of the year.

Operator

We have no further questions at this time. I’ll be turning the back to you for your closing remarks.

Darren Richardson

Okay, well thanks to everyone for joining us today and we look forward to catching you up at the end of our fourth quarter.

Operator

Ladies and gentlemen, this does conclude the conference call for today. We thank you all for your participation. Have a great evening everyone.

Darren Richardson

Thank you.

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