GigaMedia Is A Low-Quality Net-Net With High Upside

About: GigaMedia Limited (GIGM)
by: InvestForValues

GIGM is selling at 52% of its net cash value and is a great deep-value play for basket portfolios.

With a failing turnaround and no possibility of industry improvement, it is more likely to be a value trap then other net-nets.

Despite GIGM's issues, picks such as these may provide excellent average returns in the long-run.

Quantitatively, Gigamedia (NASDAQ:GIGM) looks amazing as a deep-value play. It is a net-net, selling under 50% of its net-current asset value (NCAV).

For those who don't know, NCAV is a conservative measure of liquidation value and any stock selling below it is theoretically mispriced, as you could end the business and walk away with more than it is currently worth. Businesses such as these are struggling and in many cases have major issues. The calculation follows:

NCAV: (current assets - (total liabilities + preferred stock))/outstanding shares

If this value is below 66% of its stock price, then the company is selling at a large discount to liquidation value. As a group, these stocks perform fantastically well but many of them do poorly and can become "value traps." The returns come from the select few in the portfolio which blow up for incredible returns.

Back to GIGM. Along with being priced well below NCAV, it is also priced well below net cash value - (cash - total liabilities)/outstanding shares). So if you owned GIGM outright, you could take its cash, pay off the debt, and leave with much more in cash than you paid for it. Amazing value here. Further, it has very low debt and has been growing NCAV y-o-y as opposed to destroying it. Even better, it has generated positive earnings in the past year, giving it a p/e ratio of 2.62. If this is where the analysis ended, I would be backing up the truck.

The problem is that the business is entirely unappealing, even for a net-net.

First, GIGM is in essence a holding company which owns subsidiaries in varying businesses. Its main holdings comprise of online, mobile and casino gaming firms as well as cloud computing services for local SMEs. As GIGM notes in its annual reports, it operates in a highly competitive area in which differentiation is difficult. One of its most popular games, MahJong, has been replicated by numerous others in Taiwan alone, where GIGM has most of its users. This is more significant than it seems as games require development and experimentation. It is uncertain whether GIGM can produce profitable games in the future given the glut of online games in the past few years.

Due to this, total revenues have been decreasing for GIGM in a quite linear fashion since 2010. It has a strategy of growth through acquisition, and has been acquiring other local gaming companies throughout the past five years to no avail. Most recently, GIGM has looked to diversify through any means necessary, even into completely unrelated businesses. In June 2015, GIGM arranged an agreement to acquire 70% of Strawberry Cosmetics, a cosmetics e-commerce company. As with most ill-conceived M&As, they cited major synergies as a reason for the acquisition, but it was cancelled just a few months later in October 2015 due to "instability in global economic conditions." As GIGM's main asset is cash, and since it is on a path of acquisition to attain success, it seems that they will continue to spend cash until one of its subsidiaries becomes profitable.

Revenues for its cloud services business, which begun in 2013, increased from $0.7m to $1.6m in 2014. Operating losses for this segment increased from $1.2m to $1.5m in this period. This is admirable growth but this segment will continue to consume cash in the coming years. As GIGM's revenues have declined from $34.37m in 2011 to $9.78m in 2014, and with GIGM continuing to sell its non-performing assets, cloud services will increasingly comprise a larger percentage of the total business but will have to turn a profit in the near future to improve overall business performance.

Profits also have been negative since 2010, although their losses have been reducing since then. Operating losses have been the norm since then as well, and they have only become slightly less poor in the past two years. Their profits in 2015 have all come from the disposal of marketable securities and other securities, i.e. they sold shares of their subsidiaries and other various investments for a profit. This is clearly an unsustainable mode of profitability. This is likely why GIGM's earnings are not valued at a reasonable multiple in the market.

Benjamin Graham outlines in Security Analysis what the analyst should look for and avoid in net-nets and notes that while on the whole they are brilliant, the analyst should practice discrimination in the selection of such issues, as some are less likely to perform well than others.

"He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above. Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past."

Those favorable developments which he lists are:

"1. The creation of an earning power commensurate with the company's assets. This may result from:

a. General improvement in the industry

b. Favorable change in the company's operating policies

2. A sale or merger

3. Complete or partial liquidation."

On these counts, GIGM has shown no satisfactory current or past earnings, average or otherwise. Both the gaming and cloud services industries will only get more competitive, so general industry improvement is highly unlikely in both cases. The company has been attempting a turnaround and there has been improvement, but there is no reason to expect this to last, given that improved earnings have come from the sale of poor-performing subsidiaries and operating losses have continued. Further, the acquisition policies have not helped performance and have only reduced cash. Liquidation seems unlikely given that management has stressed that it is attempting a turnaround and is incorporating the new-found cloud business into its operations. In my opinion, this leads to only a few good options.

1. Gigamedia will develop a profitable game in the next few years, which I feel it has shown unable to do.

2. It will sell the business, which it kind of has been doing in recent years.

3. It will acquire another firm leading to increased profitability, which once again it has shown unable to successfully accomplish.

4. Its cloud services business will become profitable in the near future.

When investing in net-nets it is best to look for those which may continue as an operating business and succeed in a comeback, given that only 5% of them liquidate and being acquired is chance. With many of the above mentioned turnaround options deemed highly unlikely for GIGM, the potential investor would be left with a business which has not been able to fix its issues despite attempts to do so and which may continue to flounder. The cloud services business may be a promising avenue of growth but has not been able to turn a profit as of yet. This is to be expected as this segment begun in 2013. It is possible that this can influence the turnaround of the business and provide future growth.

There is only two main positive and reassuring qualitative items I can mention, which are that the CEO continues to purchase stock at a rapid rate and management continues to emphasize the need for change.

Others on Seekin gAlpha have noted that GIGM is essentially a call option for growth, which I completely agree with. It is trading at a heavily discounted value, meaning it is less likely to drop dramatically in value. Any good bit of news could increase the stock price in a major way, and if it does manage future growth and profitability the returns will be immense. Similarly, if it were acquired it would lead to awesome returns. Nothing in the past shows they have the ability to manage the business in a profitable fashion and I'm unable to calculate the chance of GIGM being acquired by another firm, leading me to believe it is more speculative than most net-nets. The investor would essentially be hoping and waiting for the small chance of something special and spectacular to happen, as their slow turnaround has not been successful as of yet.

Despite my scathing analysis and negative outlook on the business, I hold it for a few reasons. As mentioned above, a business selling below net cash value is much less likely to decline further than other businesses. GIGM has about $75m in cash to play with (compared to its market cap of $31m) and although highly unlikely in my opinion, it could do something to make a splash. It also has been growing its NCAV and doing a good job of retaining cash, so it will not wither away unless it makes a large and unprofitable acquisition. This means that although I think it is highly speculative as an individual stock, in a portfolio of diversified net-nets it would make a great purchase due to its lower downside than others and high potential upside. This is akin to a poker player betting on a draw with a low chance of success but high pot-odds. In the long-run the poker player will do well with such a strategy as the expected return over multiple hands is positive.

I'm torn in my analysis as I believe GIGM is much more likely to be a value-trap than other firms, but again, I feel this is more likely to lead to mediocre performance than highly negative performance given that it currently sells below net cash value.

For those with a less diversified portfolio who are seeking higher quality net-nets with adequate past earnings and merely dealing with temporary issues, I recommend avoiding GIGM due to the factors mentioned above. If you are running a basket-type portfolio, it may be a great pick.

Disclosure: I am/we are long GIGM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.