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Mad Catz Interactive, Inc. (NYSEMKT:MCZ)

F4Q12 Earnings Call

June 13, 2012 5:00 p.m. EDT

Executives

Norberto Aja – IR

Darren Richardson – President and CEO

Allyson Evans – CFO

Analysts

Justin Ruiss – Sidoti & Co.

Ronald Rotter – RLR Partners

Stan Trilling – Credit Suisse

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Mad Catz Interactive fiscal 2012 fourth 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, Wednesday, June 13, 2012.

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

Norberto Aja

Thank you, operator, and good afternoon everyone and welcome to Mad Catz's fiscal 2012 fourth quarter and full year conference call. With me on the call today are Darren Richardson, Mad Catz's President and Chief Executive Officer, along with Allyson Evans, Mad Catz's Chief Financial Officer. Darren will provide an overview of the results and the principal drivers behind them. Afterwards, Allyson will review the financial results in greater detail, before turning the call back to Darren for some closing remarks.

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 the 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, June 13, 2012 and webcast includes 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 financial 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. Darren?

Darren Richardson

Thank you, Norberto, and good afternoon everyone. Thank you for joining us on our fiscal 2012 fourth quarter and full-year conference call.

Fiscal 2012 full-year results largely reflect the difficult year-ago comparison which benefited from sales of products related to specific video games and revenue from a third-party distribution agreement which has since been discontinued. We also experienced delays in launching key products for the 2012 -- 2011 holiday season, and we’re impacted by the overall economy, fundamental changes in the video game industry, marked by the transition of Nintendo’s Wii console, and the move by many casual gamers to smartphones and tablets. Even though we are not satisfied with these results, we believe a simple comparison between fiscal 2012 and fiscal 2011 is not a fully accurate indicator of the company’s direction and prospects.

Three years ago, the company made a strategic decision to shift its focus towards creation of high-value products for passionate, hard-core consumers. This shift has not happened overnight and is still ongoing. Initial success was evident in growing sales of our high-end Saitek flight simulation products, and more recently is demonstrated by a widely acclaimed Cyborg PC and Mac products, as well as our Tritton premium audio products. Each of these three brands generated sales growth in fiscal 2012. In particular, the sale of Cyborg products grew 40% to $19 million in net sales, and the sales of Tritton products grew 48% to $37 million in net sales. Total audio product net sales of $45 million accounted for over 38% of net sales, just shy of the 40% to 50% target for the fiscal 2012.

We also believe these high-end products have much longer product life spans and that the best way forward is we’ll reach a transition in the video game industry with casual gamers moving more towards tablet and smartphone gaming, leaving hard-core gamers who demand the best. We realize and understand that more growth in these key areas is needed and we’re committed to increasing our sales and marketing efforts to expand awareness of these products while keeping a sharp eye on operating expenses.

In addition to our focus on creating aspirational products, over the past few years we have expanded our geographic footprint as we continue to build a worldwide sales and marketing team. As games continue to cross geographic borders and the internet allows worldwide online competition, the company is committed to position itself as a leading provider of products that optimize the passionate video gamers’ performance on a global basis.

We opened our first international sales and marketing office in 2002 and now over 50% of our sales are generated outside the United States. Today we have sales and marketing personnel in the United States, the United Kingdom, France, Germany, Spain, Sweden, Japan, China and Hong Kong, working directly with retailers in their regions. And going forward, we plan to continue to invest in expanding our geographic reach.

We’re starting to realize the benefits from the investment to date in expanding our geographic footprint, especially in the Asia Pacific region. Sales to other countries accounted for 2% of sales in fiscal 2011, 5% of sales in fiscal 2012, and 9% of sales in the fourth quarter of fiscal 2012. We were also pleased to see European sales overcome considerable market headwinds and a difficult comp to return to double-digit growth in the fiscal fourth quarter.

In summary, our focus and our goal is to bring to market quality products that target segments within the video game industry with designs and features that are essential to their gaming experience, and make them readily available across a broader geographic base. With that, I would like to turn the call over to Allyson to provide some additional color on the results. Allyson?

Allyson Evans

Thanks, Darren. Let me begin with a brief review of the income statement.

Net sales for fiscal 2012 were $117.6 million, down 36% from a record $184 million in fiscal 2011. The drop in net sales was primarily driven by a significant slowdown in sales of products related to Rock Band 3 which launched in September 2010. To a larger extent, the full-year results were also negatively impacted by the continued deterioration of PS3 and Wii-related gaming product sales.

Looking at our sales in greater detail, North America declined approximately 49% to $57.4 million in fiscal 2012 and represented 49% of total net sales for the year, compared to 62% of sales in the prior-year period. European net sales declined 18% to $54.5 million in fiscal 2012 and represented 46% of total net sales compared to 36% of net sales in the prior year. Sales of Rock Band 3 were considerably weaker in North America, while our European sales were impacted by reduced contribution from our distribution of third-party products. Net sales to other geographies increased 40% to $5.7 million, representing 5% of total fiscal 2012 net sales compared to 2% in fiscal 2011.

Gross profit margin fell to 27% in fiscal 2012 from 29% in the prior year, largely due to higher inventory reserve recorded during fiscal 2012 and reduced fixed-cost leverage based on lower sales volume. Our gross margin performance for the full year is within the guidance range we set out at the beginning of the year.

Total operating expenses for the year rose 2% to $35.4 million, representing 30% of net sales and leading to an operating loss of $3.9 million in fiscal 2012. This compares to $34.6 million of operating expenses in the prior fiscal year, or 19% of sales, and operating income of $18.8 million. The increase in operating expenses was primarily driven by our ongoing investment in geographic sales expansion and research and development activities which have resulted in our strong current and future product pipeline.

For the year, the company recorded a foreign exchange loss of $0.6 million compared to a foreign exchange gain of $1.2 million a year ago. The loss was primarily due to the fluctuation of the British pound and euro against the US dollar and Hong Kong dollar.

After an income tax benefit of $1.3 million compared to income tax expense of $6.4 million in the prior year, net loss for the fiscal year ended March 31, 2012 was $1.6 million or $0.03 per diluted share, compared to net income of $10.9 million or $0.18 per diluted share in the prior fiscal year. Adjusted EBITDA, a widely-used measure to monitor financial performance, was a loss of $1.1 million in fiscal 2012, compared to a gain of $23 million in the prior year.

Moving on to the fiscal 2012 fourth quarter, net sales were $29.2 million, a decrease of 13% from $33.7 million in the fiscal 2011 fourth quarter. North American net sales were down 35% to $13.9 million in the fiscal 2012 fourth quarter, representing 48% of quarterly net sales. This compares with 64% of sales in the prior-year period. European net sales rose 14% to $12.7 million in the fiscal 2012 fourth quarter and represented 43% of quarterly net sales compared to 33% of quarterly net sales in the prior period. Net sales to other geographies increased 124% to $2.6 million, representing 9% of quarterly net sales in the fiscal 2012 fourth quarter.

We’ve previously stated that our goal is to maintain gross margins above 30%, so we are pleased to announce that our fourth quarter gross margin of 31% represents progress toward this goal. Gross profit declined 15% to $8.9 million from $10.5 million in the same quarter of the prior year, primarily due to the lower sales volume.

Total operating expenses for the fourth quarter of fiscal 2012 fell 4% to $8.5 million, representing 29% of net sales and driving an operating profit of $0.4 million in the quarter. This compares favorably to $8.9 million of operating expenses in the comparable prior year, representing 26% of net sales and operating income $1.7 million.

Foreign exchange loss was $0.2 million, compared to a gain of $1.2 million in the fiscal 2011 fourth quarter. As noted in my comments about the full year, currency fluctuations between the British pound and euro against the US dollar and Hong Kong dollar were the primary drivers of the foreign exchange loss for the quarter.

After an income tax benefit of $1 million versus tax expense of $0.8 million in the prior-year period, net income for the fiscal 2012 fourth quarter was $0.8 million or $0.01 per diluted share, compared to net income of $1.5 million or $0.03 per diluted share in the fourth quarter last year. Adjusted EBITDA decreased to $1.1 million in the quarter from $3.6 million in the fiscal 2011 fourth quarter.

Moving on to our balance sheet, as of March 31, 2012, we reported borrowings under the revolving credit facility of $16.7 million and a net position of bank loan less cash of $14.2 million. This compares to borrowings of $5.4 million and a net position of bank loan less cash of $1.7 million as of March 31, 2011. Long-term debt of $14.5 million as of March 31, 2011 was fully repaid during fiscal 2012, and we are currently in negotiations with Wells Fargo to renew our credit facility. We have agreed to interim covenant levels that we are in compliance with at yearend and we believe will be achievable going forward.

Inventory of $32.5 million is up 16% from $28 million last year, primarily related to higher levels of Tritton products. Inventory turns on a trailing fourth quarter basis were 3 times, down from 5.6 times in the prior fourth quarter period. Subsequent to yearend, we have made progress in reducing our inventory and we’ll continue to strive to make further reductions.

Accounts receivable of $15.5 million declined from $19.8 million at the end of the prior fiscal year, primarily reflecting lower sales volumes during the fiscal 2012 fourth quarter. Our growth DSOs were 86 days compared to 104 days a year ago.

Cash used in operation during fiscal 2012 was $5.4 million compared to cash provided by operations of $3.3 million in fiscal 2011. The primary use of cash in fiscal 2012 was increased inventories of $4.8 million. Cash used in investing activities in fiscal 2012 was $2.4 million compared to $3.6 million in the prior year. The primary decrease in investing activities reflects the Tritton and V Max acquisitions completed during fiscal 2011.

Cash provided by financing activities in fiscal 2012 was $6.6 million compared to $1.6 million during fiscal 2011. This increase primarily reflects capital raised from the [pikes] completed in April 2011 and increased borrowings under the company’s line of credit, partially offset by the repayment of the long-term debt balance.

I’d now like to turn the call back to Darren for some closing remarks. Darren?

Darren Richardson

Thanks, Allyson.

In fiscal 2011 we benefited from discreet opportunities to partner with premium game titles and will continue to look at such opportunities like our recently announced Halo 4 agreement, and to [shoot] them when they make financial sense. However, we believe that the long-term growth and financial health of the company depends on creating must-have products for passionate consumers that do not rely solely on outside sources for their success. We’re seeing strong sales to date this quarter and are expecting a return to growth in the first quarter of fiscal 2013.

We’re also excited about our pipeline of new products for the holiday season, with some key new releases, including the highly-anticipated Warhead 7.1 headset going into mass production in the next few weeks. We expect these products to make a positive contribution to fiscal 2013’s second quarter sales and are optimistic that their early launch will contribute to our return to growth in fiscal 2013.

We’re pleased to see margins return to the 30% range in the fiscal fourth quarter. If we can sustain margins in the 30% range and return to growth, then we should also be well-positioned for a full -- for a return to profitability in fiscal 2013.

We just returned from the annual E3 Trade Show in Los Angeles and feel very positive about the experience. We were able to showcase some of our key current products and preview select upcoming products, as well as meet with our distribution partners and key members of the press. I'm pleased to say that we received very positive feedback, most notably around our Warhead 7.1 headset, our range of Kunai headsets, our new video game Damage Inc Pacific Squadron World War II which was playable using the custom flight stick that will be launched alongside the game, and our range of Wii U products which include a Tritton headset to accompany the console at launch. We also received a broad spectrum of coverage from notable outlets such as GameSpot and Gadget and many more members of the top-tier media.

Looking ahead, we have a range of exciting initiatives that should benefit fiscal 2013. Our line of audio products is now in wide distribution. We’re expanding the audio line to new platforms. We’re expanding our line of universally acclaimed R.A.T. PC and Mac products, and we plan to step up our marketing activities.

We’ll continue to carefully select targeted software opportunities that pose manageable downside risks by complementing our hardware initiatives. We’re also committed to supporting the professional gaming community and developing products that live up to their exacting demands.

That concludes my prepared remarks for today. Before we move into the Q&A session, I want to take a moment to thank the entire team at Mad Catz for their continued dedication.

I will now turn the call back to the operator so we can answer any question. Thanks. Operator?

Question-and-Answer Session

Operator

Yes, sir. Thank you very much. (Operator Instructions).

And our first question comes from the line of Justin Ruiss with Sidoti & Co. Your line is open.

Justin Ruiss – Sidoti & Co.

Good afternoon.

Darren Richardson

Hi, Justin, how are you?

Justin Ruiss – Sidoti & Co.

Good. I'm doing well. How are you?

Darren Richardson

Good. Thank you.

Justin Ruiss – Sidoti & Co.

I just wanted to just touch upon -- I know you're trying to expand that geographic footprint, and I'm not sure if you're trying to build upon the sales team that you have or you're trying to just leverage the amount that you're using at this point.

Darren Richardson

I think the key thing there is we’re adding new sales people in region. We’ve had distributors in most countries for a long time, but we’re supplementing that with our own sales people. And in certain instances, opening distribution centers to support that as well. So if you take Japan, for example, we had a distributor there. We now have a couple of people in Japan and we also have a distribution center in Japan that allows us to sell direct into the retail channel and manage a lot of that ourselves, as well as having marketing people supporting the sales effort so that we can drive marketing initiatives in the local market. And we’re doing that in multiple different areas around Asia Pacific.

Over the last year or two years, we’ve added people in Spain, Scandinavia, Hong Kong, China. So we have sales people in Beijing as well as Hong Kong and Shenzhen. And so -- and we want to continue to grow out our sales in that region. And we’re actually seeing really positive results. So we’ve got great products, people want the products, and we just have to do a better job of getting the products to them in a very streamlined manner, and then to back that up with some stronger marketing and promotional support.

Justin Ruiss – Sidoti & Co.

Got you. And I guess it’s a little bit of a combination then of using distributing partners and --

Darren Richardson

Yeah, absolutely. I mean, what we typically see, we have the same thing when we’re building out our European sales and marketing platform sort of 10 years ago, is it really takes one to three years to get up to breakeven or better. But once you kind of get up over that threshold, then you really start to have a business that’s quite meaningful. And so, for the last couple of years, we’ve talked about our intent to continue growing the geographic footprint, and it’s working for us. You can see that in the sales run rate that we’re getting out of the rest-of-the-world territories.

Justin Ruiss – Sidoti & Co.

And then just one other thing, are you actively scouting out to partner up with other license games like as is what you're doing with the Halo 4? Is that an active seeking out or is it once over a time with the geographic expansion or?

Darren Richardson

No, that’s an active seeking out. And that actually provides additional products that we can flow through and leverage that broader distribution footprint.

Justin Ruiss – Sidoti & Co.

Yeah, okay. All right. Well, thank you very much.

Darren Richardson

You're welcome.

Operator

And our next question comes from the line of Ronald Rotter with RLR Partners. Your line is open.

Ronald Rotter – RLR Partners

Hi guys. Along with Justin’s prior question, Europe seems like a real anomaly. The first three-quarter sales were down roughly 20-plus percent. I mean, Europe is the one area that most people are talking about having really dismal results out of, and you had up numbers in the fourth quarter after having successive down quarters out of Europe. Was there anything in particular in the fourth quarter that accounted for the sales increase? Was it a new retailer that you had a pipeline fill of? Is -- I mean, can you foresee in upcoming quarters of also positive numbers coming out of Europe? Could you talk what happened in Europe in that fourth quarter there?

Darren Richardson

Yeah. I think the European performance has been very, very strong given where the industry is going. But a small part of it is because we’re now actually working on a direct basis with more retailers in different regions. I think the most significant thing is we had a very difficult comp because we had a third-party distribution agreement in there that pitted out at the end of Q4 last year, so we had I think around $1 million worth of sales or just shy of $1 million worth of sales from that agreement. And then secondly, Rock Band wasn’t nearly as successful in Europe as it was in North America. And so you still had a fairly strong tail of Rock Band sales in North America in Q4 of last year.

And so what you're seeing is really the benefit of the Cyborg line as well as the Tritton line doing well in Europe and finally getting past what’s been a difficult comp as that third-party distribution agreement plus the Rock Band sales from the prior year sort of wind their way up.

Ronald Rotter – RLR Partners

And you had mentioned in the last quarter, which was obviously in the December quarter, which was I guess horrendous, to put it kindly, that you would know by now in terms of retail resets, you said most of them would be occurring in May where you stood as far as going into the remainder of the year. Could you talk about how the results of those retail resets, what you got, what you didn’t get?

Darren Richardson

Yeah, and we’ve pretty much executed the bulk of those now, which has been a big contributor to driving the growth in Q1. I think the bigger macro picture there is I know last quarter I was trying to sort of demonstrate the trend that’s happening where if you go back four years, we had $80 million of sales and about $70 million of that $80 million was predominantly commodity product.

Ronald Rotter – RLR Partners

Right.

Darren Richardson

And now that they get through to the end of 2012, four years later, the commodity products are pretty much going out of the business. So we’ve really hit this inflection point where we’re now starting to book real solid growth over and above -- and we don’t have that offsetting decline of the commodity products.

So we feel pretty good about how this year is going to shake out. And we achieved that in Europe in spite of what is still a very difficult economy and a difficult retail environment, because there’s a number of our European retailers that are going through some tough times as well. So there’s a lot of market dislocation. However, we’re focused on gaming audio, which is a very high-growth category, as well as hard-core PC gaming which is also a growth category. So, over the last couple of years we’ve been able to position the product line into the segments of the business that have good, strong growth.

And we believe that growth is certainly sustainable in the near term, providing that the economy doesn’t get any worse and that the video game business continues to at least [trend at along] the way it’s going. I mean, obviously a stronger industry would help, a stronger economy would help, but I think overall the strategy is playing out positively.

Ronald Rotter – RLR Partners

I guess, most specifically, it appears like in the last -- in the holiday period, due to your inability to produce product, it appears that Tritton lost shelf space specifically in Best Buy and in GameStop to Turtle Beach. And I guess my question is, are you -- do you see regaining some of that shelf space?

Darren Richardson

Yeah, we didn’t so much lose the shelf space as we didn’t have the product ready to on the shelf. Now we’ve got the products on the shelf. So we’ve actually gained shelf space quite significantly in the last two to three months. And so we’re in a much, much stronger position today than we were three months ago.

Ronald Rotter – RLR Partners

Okay. I have some more questions but I’ll defer to others and get back to you later.

Darren Richardson

Okay. Thank you.

Ronald Rotter – RLR Partners

Thank you.

Operator

(Operator Instructions). Our next question comes from the line of Stan Trilling with Credit Suisse. Your line is open.

Stan Trilling – Credit Suisse

Good afternoon, gentlemen. Good news that Warhead is going to be mass produced in the next couple of weeks. When do you expect products in the stores?

Darren Richardson

It’s probably going to be around the August timeframe. We’re still working on the actual launch strategy with retailers, so, some of that’s going to be retailer-dependent. But you're typically looking at three to five weeks on the [water] based on North America and Europe. So it’s going to be more of an August event than, you know, if all things go well, maybe the very tail-end of July, but I think more realistically it’s going to be August. So it should be comfortably Q2.

Stan Trilling – Credit Suisse

Okay. And I -- Ron’s question regarding the resets, I didn’t understand your answer or if there was an answer. Have you had resets for Warhead from the major retailers?

Darren Richardson

Well, the Warhead hasn’t shipped yet, so they won’t -- there hasn’t been a reset. But it will go into major retailers, yes.

Stan Trilling – Credit Suisse

Okay. And the other question has to do with, when would you expect us to see some product reviews on the Warhead in some of the gaming magazines?

Darren Richardson

Well, we had a good showing at CES and got a lot of reviews through from CES. We also had good showing at E3 and preliminary sort of show-and-tell. The detailed reviews will come once we have mass production units that will go out to the general. So, probably, I would say, in and around the time of launch, which is when you want to create the buzz around the launch of the product.

Stan Trilling – Credit Suisse

Okay, thanks. And the other -- my last question has to do with the new -- the announcement about he Halo product. How is that different from the Warhead?

Darren Richardson

There’ll be a couple of different tweaks done to the product. Graphically it will align with a lot of the sort of game elements, and there’ll be a couple of other bits and pieces that we haven’t announced yet that will come through with it as well.

Stan Trilling – Credit Suisse

Okay. And the market for that product is, would you say, is the same, smaller or larger than the markets for Warhead?

Darren Richardson

It’ll be a subset of Warhead and it’ll be a subset of some of the other products that we do out there. The big thing with things like Halo, just like back when we did Call of Duty, is it gives a great promotional vehicle to tie into the game and get great in-store presence in and around the holiday. So it’ll be strong. But I think the Warhead as the standalone SKU will be a more significant product.

Stan Trilling – Credit Suisse

Okay. And the very last question has to do with the inventory build-up, the four-plus million dollars. Was that build-up for Warhead?

Darren Richardson

No. A lot of the inventory build-up was really that we really placed purchase orders for the holiday period and so that product arrived late but still arrived. And we ended up -- it’s going to take a couple of months to work that through. But we’re really starting to make some solid inroads on that over the last couple of months.

Stan Trilling – Credit Suisse

Okay. Thank you and good luck.

Darren Richardson

Okay. Thanks, Stan.

Operator

And Mr. Richardson, there are no further questions at present time. I’ll turn the call back to yourself.

Darren Richardson

Well, thank you to everyone for joining the call today. We look forward to updating you on our progress as we move through the balance of fiscal 2013. Thanks a lot.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Thank you again. Have a great day.

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