GigaMedia Will Survive Current VIE Turmoil

| About: GigaMedia Limited (GIGM)

I am following GigaMedia (NASDAQ:GIGM). GigaMedia was incorporated in September 1999 as a company limited by shares organized under the laws of the Republic of Singapore and completed an initial public offering of its shares on the Nasdaq on February 24, 2000. GigaMedia is a major provider of online entertainment software and services. Through its subsidiaries, the company develops and operates a suite of online games in Asia covering the regions of Greater China and Southeast Asia.

The company is in a turnaround situation and personally I think they can survive the turmoil that has been going on because of some VIE's (Variable Interest Entities) they have had since May 2006. In that year GigaMedia entered an exclusive partnership with and strategic investment in online casual games company T2CN Holding Limited. T2CN is a leading online sports casual game operator in China with over 21 million registered users.

U.S. listed Chinese companies frequently use VIEs to operate in China. A VIE is an entity that is not owned by the public company, but is allowed to be consolidated in the financial statements because it is controlled through agreements. The assumption that the U.S. listed company is a going concern may rest on whether those agreements are enforceable.

There appear to be two ways that a VIE structure might collapse. The first would be an outright attack by the Chinese government. Many of the VIEs were constructed to circumvent government restriction on foreign investment in certain sectors. The government could simply prohibit any agreement that transfers control, directly or indirectly, of any company in prohibited industries to foreigners. Such an attack would follow the Western concept of voiding contracts that are contrary to public policy.

The other way a VIE structure might collapse is if the legal owner of the VIE decides to take his company back and breach the VIE agreements. This is the case with GigaMedia's majority owned subsidiary T2CN. In most cases it is unlikely to happen, since the legal owner of the VIE is also the majority shareholder, and typically the CEO, of the listed company. But if the VIE owner were forced out of the public company, it is possible that he or she may choose to take the VIE with him/her. The public company would then have to sue in Chinese courts to enforce the agreement, like in the case of Gigamedia.

We will then learn how substantial the substantial uncertainty might be. I would not want to be in the shoes of GigaMedia trying to sue a politically connected local businessman in a provincial court for enforcement of an agreement that arguably circumvented public policy.

Back to accounting. All of the disclosures about the risk of VIEs are included in the annual filing on Form 20F in the risk section.

The contractual arrangements with T2 Entertainment, T2 Advertisement and Jinyou and their shareholders may not be as effective in providing operational control as direct ownership and the shareholders of T2 Entertainment. We operate our online games business through T2 Entertainment, T2 Advertisement and Jinyou, all of which are ourVIEs. We have no ownership interest in any of these VIEs and rely on a series of contractual arrangements that are intended to give us effective control over them. However, the contractual arrangements may not be as effective as compared to having direct ownership and control over these companies. Direct ownership would allow us, for example, to directly exercise our rights as a shareholder to effect changes in the board of directors, which, in turn, could affect changes, at the management level. In addition, these VIEs could violate their contractual arrangements with us, go bankrupt, suffer from problems in their businesses or otherwise become unable to perform their contracts with us. As a result, our business could be disrupted and our results of operations may be materially and adversely affected. Most principal shareholders of T2 Entertainment, T2 Advertisement and Jinyou are executive officers of T2CN and have no substantial shareholdings in our Company. Thus, their interests as shareholders of the VIEs and their duties to our Company may conflict. We cannot assure you that when conflicts of interest arise, these persons will act completely in our interests or that conflicts of interests will be resolved in our favor. Any legal proceeding could result in the disruption of our business, diversion of our resources and the incurring of substantial costs. All of these contractual arrangements are governed by PRC laws and provide for the resolution of disputes through either arbitration or litigation in the PRC. Accordingly, the underlying contracts would be interpreted in accordance with PRC laws and any disputes would be resolved in accordance with PRC legal procedures. The legal environment in the PRC is not as developed as in other jurisdictions, such as the United States. As a result, uncertainties in the PRC legal system could limit our ability to enforce these contractual arrangements. In the event we are unable to enforce these contractual arrangements, we may be unable to exert effective control over our PRC operating VIEs, and our ability to conduct our business may be negatively affected.

The GigaMedia story is a problematic one which almost ruined the company. The dispute with Wang Ji of T2CN has prevented GigaMedia from obtaining the financial information necessary to report the financial results of their subsidiary T2CN, the company has effectively lost control over T2CN's financial reporting process, because they don't have access anymore.Therefore, GigaMedia deconsolidated T2CN's results with effect from July 1, 2010.

This had of course a major impact on their business the last quarters. On May 26 they announced Q1 results. Revenues were $10.4 million, up 17% quarter-over-quarter. First quarter core net loss was $975 thousand; core basic and fully diluted loss per share were each $0.02.

On May 23 the company announced that its board of directors had approved a US$11 million share repurchase program of the company's common stock.

Under the terms of the approved program, GigaMedia may purchase up to US$11 million worth of its issued and outstanding shares beginning from June 1, 2011. The company plans to fund repurchases made under this program from the company's available cash balance and plans to cancel all repurchased shares.

With available cash of more than $60 million or $1.10 per share, it looks like a bargain at the current price of $1.27. Book value per share stands at $3.70.

Of course they are still early in the process of turning around their operations and financial performance, but first quarter results show the company is beginning to move in the right direction.

The most compelling part of the story is the increase in MMO revenues and the focus on Asian markets such as Vietnam, Thailand and Indonesia. For risk investors GigaMedia is a Poker Stock (they own 40% of Everest Poker) with enough upward potential. Personally I expect they could get profitable in Q3 and Q4.

Disclosure: I am long GIGM.