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Introduction to Merger Arbitrage Mondays

March 15, 2010 | Merger Arbitrage | Author Asif

We are introducing a new service on SINLetter called Merger Arbitrage Mondays to highlight merger arbitrage opportunities that exist in acquisitions that are yet to be completed. If you are not familiar with merger or risk arbitrage, you can read about it in a section of the March 2009 investment newsletter titled Merger Arbitrage and the Pfizer-Wyeth Deal. That deal delivered gains of 27.34% including dividends over a 7.5 month period. On an annualized basis gains were 43.77%.

I currently have a position in network equipment maker 3Com (COMS) in my personal portfolio as a merger arbitrage play on Hewlett Packard (HPQ) completing the acquisition of 3Com at some point during the first half of 2010. As mentioned in this tweet, the spread offered by this deal in early February when I sent the tweet was 5.89% or 14.725% annualized even if the deal closed as late as 6/30/2010. The spread has narrowed considerably since then as 3Com’s stock has risen to $7.74 and is now very close to the $7.90 a share that HP has offered to acquire 3Com.

The goal of Merger Arbitrage Mondays is to present all the merger opportunities out there along with their calculated absolute returns and annualized returns. We started working on this at the start of this year and hence deals announced prior to 1/1/2010 (like the HP-3COM deal) are not included in the table below. Once we build out this Merger Arbitrage service with features like an automatically updating portfolio of Merger Arbitrage opportunities accessible at any time,  we will roll it into the Special Reports service to provide better value for subscribers who now only get reports once a quarter. Until then Merger Arbitrage Mondays will be free for everyone.

Please note that Merger Arbitrage is also referred to as Risk Arbitrage for a reason. These deals do fall apart from time to time and there is no free lunch while investing. We have attempted to reduce the amount of work you have to do to identify interesting deals but we strongly recommend doing your own research and consulting with your broker/investment adviser before taking any action. We do not warrant the completeness or accuracy of the content or data provided in this Merger Arbitrage service.

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Blizzard’s World of Warcraft: The China Growth Story

March 11, 2010 | SIN Picks | Author Asif

The Blizzard division of Activision Blizzard (ATVI) generated $1.2 billion in annual revenue last year without releasing a single new game in 2009. Blizzard still gets some of its revenue from legacy games like the original Starcraft that was released more than a decade ago in 1998. In fact Starcraft managed to crack the list of top 10 PC games as recently as May 2009 according to the top game industry research firm NPD Group. Starcraft has been spotted in the top 20 multiple times since the announcement of Starcraft 2 in 2007. The beta version of Starcraft 2 featured in the video below was released last month and the game is expected to ship sometime in the first half of 2010.

A majority of Blizzard’s revenue however comes from its hugely popular MMORPG World of Warcraft (WoW) that had 11.5 million subscribers as of last month and has helped Blizzard generate above average operating margins when compared to Activision as a whole. Operating margins for the Blizzard division in 2009 were over 46%. Given how important World of Warcraft numbers are to Activision, I decided to dig into the subscriber numbers and specifically look at the growth opportunity from China as I have received a couple of questions about this from SINLetter subscribers.

As you can see from the chart below, World of Warcraft experienced exponential growth from its launch in November 2004 through 2008. Only Second Life by San Francisco based Linden Labs, which unlike WoW is free to play, managed to surpass WoW’s subscription numbers. Keen followers of the Massively Multiplayer Online Gaming space noted that the 11.5 million subscribers that Activision Blizzard reported at the end of 2009 were the exact same number of subscribers reported at the end of 2008.

With WoW restored in China as of September 19, 2009 following regulatory hurdles, are subscription numbers going to start growing again or has WoW peaked until the next expansion pack Cataclysm comes along? The bigger question to ask is how many of the 11.5 million subscribers are from China and how much revenue do they generate for Activision Blizzard.

If all 11.5 million subscribers were paying $15/month or $180 annually to play WoW, Blizzard’s revenue from just this one online source would be,

$15 X 12 months X 11.5 million subscribers = $2.07 billion.

Even after averaging the monthly fee down to roughly $14 after taking into account that some subscribers pick the cheaper $13.99 plan by paying for three months at a time or the $12.99 plan by paying for 6 months upfront, the expected revenue drops to,

$14 X 12 months X 11.5 million subscribers = $1.93 billion.

This is significantly higher than the $1.2 billion in revenue the entire Blizzard division reported for 2009. So it stands to reason that a large number of these 11.5 million subscribers are Chinese subscribers that don’t shell out roughly $14/month like their North American and European counterparts do. Based on what I have read from various sources, it is possible that between 4 to 6 millions subscribers are from China and they pay 6 cents per hour to play the game. Assuming 5.5 million subscribers and adopting a conservative estimate of 10 hours played per month, annual Chinese revenue works out to,

10 hours X $0.06 X 12 months X 5.5 million subscribers = 39.6 million

Chinese revenue is probably even smaller after Activision splits the proceeds with its Chinese partner Netease.com (NTES). The rest of the non-Chinese 6 million subscribers generate approximately $1 billion in revenue, putting the total WoW subscription revenue at $1.04 billion. Taking the sales of legacy titles like Diablo, Starcraft, etc., into account, we get very close to the $1.2 billion in annual revenue Blizzard reported for 2009.

There is a good chance that given the addictive nature of the game, Chinese players spend more than 10 hours/month playing the game and that the release of expansion packs (some of the old ones have not yet been approved in China) might drive additional revenue. But even if you were to double both the hours and the number of subscribers, revenue would top out at $158.4 million before Netease takes its cut.

The conclusion I came to after digging into the China factor was that the Activision Blizzard investment thesis cannot rest on expectations of growth from China. The strong pipeline of games from Blizzard for 2010 and the potential of another MMORPG are better reasons to get excited about Activision.

Related Posts:

Thoughts on Activision Blizzard’s Q4 Results

Ten Reasons I am Buying Activision Blizzard (ATVI)

Activision Blizzard: Playing Diablo’s Advocate

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The Apple App Store Ecosystem and Glu Mobile – Part 2

March 10, 2010 | SIN Picks | Author Asif

Note: This blog entry was originally published as a Special Reports update on 3/10/2010 and is now open to everyone.

Glu Mobile (GLUU) $0.98

With 38 games currently in the Apple app store, San Mateo, California based Glu Mobile is smack in the middle of the nearly $3 billion Apple app store ecosystem discussed in the first part of this two part article. Founded in 2001, Glu was once a successful start-up, focused on producing and publishing games for mid-range handsets that were the prevailing, dominant phone of the time. The years 2000-2001 were when cell phone usage became a widespread trend and Glu had precociously jumped on the idea that gaming would take off on this technology. Glu not only publishes original game titles but also has partnerships with SINLetter portfolio pick Activision (ATVI) and other companies like Sony (SNE), Microsoft (MSFT) and Popcap Games. For example Activision’s Guitar Hero 5 is published as Guitar Hero 5 Mobile for Blackberry, Android, Microsoft and Palm based phones by Glu. The company was brought public in early 2007 at a price of $11.50 per share with Goldman Sachs as the lead underwriter. With offices in 11 countries, Glu  has been losing money every year since 2005 and the $84 million it raised in the March 2007 IPO has dwindled to just $10.5 million in cash as of December 31, 2009.

Unfortunately, Glu has been struggling to keep up with mobile gaming trends as they have shifted to phones like the iPhone and this is reflected in the stock price, which is just under a buck as I write this article. In an attempt to reformulate their approach to gaming, Glu posted a press release on July 8, 2009 informing investors and the public that their CEO for the past six years, Greg Ballard would be leaving Glu in “pursuit of other activities.” It was only two months ago, on January 04, 2010, that Glu publicly announced their newly appointed CEO Niccolo de Masi, a man with a strong background in various mobile gaming sectors, including London Stock Exchange listed MonsterMob and Hands-On Mobile, the latter of which is one of Glu’s main competitors.

It is interesting to note that Niccolo quietly replaced David White as the CEO of Hands-On Mobile near the end of 2009, also in an attempt to recoup the company’s struggling finances for a future, heavier focus on the Facebook and iPhone gaming world. Curiously enough, Hands-On Mobile just lost one of its priced mobile licences – Activision’s Guitar Hero – to rival Glu Mobile during the summer of 2009, right before Niccolo was appointed CEO, and before Niccolo left and joined Glu. Seems like Niccolo knows something we don’t – or, at least, he carries a certain faith in these smaller companies, particularly when he’s given a non-qualified stock option to purchase 1,250,000 shares of Glu’s common stock at a strike price of $1.21.

In a recent interview with PocketGamer Glu’s new CEO announced “We’re in the middle of the storm at the moment, but over a three to five year period we expect the market to grow multiple times and see our revenues in the hundreds of millions of dollars. I’m very optimistic.” Digging under the hood, Mr. De Masi has his work cut out for him considering the fact that Glu has seen sequential revenue drop in every quarter of 2009. Full year 2009 revenue also dropped to $79.3 million when compared to $89.8 million in 2008. Q1 2010 revenue is expected to be $15 to $15.5 million when compared to Q1 2009 revenue of $20.77 million. The mid-point of Q1 2010 guidance represents a drop of 26.59% in revenue. Given that the company’s only has $10.5 million of cash on its balance sheet as of December 31, 2009 and $16.4 million in short-term debt, Glu does not have a  very long runway to get its strategy right and there is a distinct possibility that existing shareholders may face dilution if the company raises additional capital.

So why did I decide to explore the market size of the Apple (AAPL) app store ecosystem and Glu in such detail? There are some glimmers of hope for this microcap stock, which the market appears to have priced for bankruptcy. I have broken down both the bull and bear case for Glu below. A number of email exchanges with a San Francisco based institutional investor who reached out to me after reading part 1 of this article, helped crystallize some of these arguments.

The Bull Case:

1. There appears to be a huge disconnect between private market valuations of mobile gaming companies and public companies like Glu. As mentioned in part 1 of this article, San Francisco based mobile gaming start-up ngmoco managed to raise $40 million in three rounds since launching in 2008. The post-money valuation numbers are not public but it could easily be in the hundreds of millions of dollars. In contrast Glu’s market cap as of Tuesday’s close is just $29.72 million despite operating in the exact same space as companies like ngmoco.

2. The company should be given credit for bringing down its operational and development expenses in 2009 when compared to 2008. The net loss of $6.88 million in Q4 2009 is significantly lower than a loss of $37.22 million in Q4 2008, even after you take out the $22.88 million goodwill impairment charge from the Q4 2008 results.

3. The new CEO’s interests are aligned with those of shareholders as his options have a strike price of $1.21, while the stock is currently trading at 98 cents.

4. One of the VC backers of Glu, Hany Nada, acquired over 400,000 shares on the open market at a price of $1.04 less than 7 months ago.

5. Having tried out Glu games like Super K.O. Boxing 2, which received a glowing review from Jackie on AppStruck, I can personally attest to the superior graphics and mostly bug free game play of Glu games. Glu currently has 38 apps in the iTunes app store, out of which 17 are free or lite versions of paid apps.

6. The company is porting its titles to other platforms such as the release of Family Guy on the Blackberry and Glyder 2 on Palm. Glu stands to gain not only from the red hot growth of the Apple app store ecosystem but also from the increasing adoption of other smart phone platforms (Android, Palm, etc) by consumers.

7. The recent partnership with Activision should not only help Glu capitalize on well known franchises like Guitar Hero but also position it well for an acquisition.

8. When compared to peers, the stock trades at an incredibly cheap 0.37 times sales and has an EV/Revenue ratio of 0.45.

The Bear Case:

1. Despite an established presence in the mobile gaming market, Glu did not have the foresight to act swiftly when the Apple app store was launched. This lack of strategic thinking has foreshadowed Glu’s results over the last few years and the market is rightfully skeptical of a turnaround at this juncture. Even with twin tail winds of a red hot app store and smart phone adoption, revenue declined in 2009.

2. The company has yet to fully explore the use of business models like in app purchases that have been highly successful for companies like Zynga through their social media games like Farmville and Fishville.

3. The Apple app store has over 160,000 apps vying for attention and it is difficult for Glu to keep its games in the spotlight long enough to earn a good return on investment. I did not find a single Glu game amongst the top 50 paid or free games on the app store tonight. I have in the past seen a number of their games in the top 50 rankings but Glu needs to develop the staying power of apps like Doodle Jump and Pocket God. Doodle Jump was developed by two brothers out of New York and recently broke through 3 million downloads. Pocket God has built a cult following by releasing fresh updates almost every week.

4. Glu’s balance sheet is not very strong (current ratio 0.93) and the company could face liquidity concerns when the short-term debt comes due. The $10 million in cash and a revolving credit facility should however give the company some breathing room.

An investment in Glu at this point is like buying a call option that might expire worthless or generate very good returns. It is also a vote of confidence in the new CEO and his ability to either turn the company around or prime it for an acquisition. Given that his interests are aligned with ours, the open market purchase by a VC, the low valuation, the strong stable of games that are being ported to other platforms and the recent deal with Activision, I am willing to start a position in Glu for my personal portfolio. The size of the position might be a little smaller than my standard position size of 5% so that the portfolio is not adversely impacted should the investment not work out. I am also going to purchase 3,000 shares of Glu for the SINLetter Special Reports Portfolio.

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The Apple App Store Ecosystem and Glu Mobile – Part 1

March 4, 2010 | Stocks | Author Asif

Note: As mentioned in the March 2010 newsletter, we recently migrated to a new platform and this is the first article on this new platform. I would appreciate your feedback letting me know if the content of this email displayed properly in your email client.

The app store by Apple (AAPL) has been immensely successful since its launch on July 10, 2008 and has been the subject of countless media articles like this Dec 2009 New York Times article gushing about how it has helped certain developers become millionaires overnight. One billion apps were downloaded from the app store by April 23, 2009 and it was just 5 months later that Apple announced on September 28, 2009 that downloads had topped more than 2 billion. It took the app store just over 3 months to hit 3 billion downloads by January 5, 2010.

Everyone from mom and pop development shops to current SINLetter portfolio holding Activision Blizzard (ATVI) want in on this gold rush. Just like the California Gold Rush in the mid nineteenth century, it is often the people selling the tools that may end up becoming rich after the easy gold had been mined by early arrivals. This article is about those developers and companies that have tried to capture some of the app store magic only to find their apps disappear in a vast ocean of more than 160,000 apps.

One of the first iPhone games we reviewed on our sister site AppStruck shortly after its launch in May 2009 was a game with stunning graphics called Glyder published by a company called Glu Mobile (GLUU) that is listed on the Nasdaq stock exchange. There are just a handful of public game companies and when I found Glu, I decided to kick its tires to see if it was an investment worth considering especially given its focus on building games for the iPhone and the iPod touch. But before we get into the specifics of Glu, I figured it might be a good idea to get a reading on the market size.

Size of the App Store Ecosystem:

One of the first things a venture capitalist wants to know when you enter a room with your business plan is the size of the market and what portion of that market you expect to capture. The perception of the sheer size of the App Store ecosystem is one of the reasons start-ups like ngmoco have managed to raise $40 million from venture capital funds over the last two years. In stark contrast, Glu, which targets the exact same market, has a market cap of just $25.7 million.

The size of the App Store ecosystem has been a subject of lot of discussion and probably even Apple does not have the answer to it because the ecosystem not only includes the sales of apps through the App Store but also in app purchases of virtual goods and advertising revenue. Mining through the database of apps we built on AppStruck, I found that over 24% of the nearly 160,000 apps in the app store were free and 42% of them were priced at $0.99. Given below is the price distribution for 95% of the apps in the app store.

While having lunch in San Francisco with Jeff Scott, the founder of the leading iPhone app review site 148Apps.com and the Best App Ever Awards, we started discussing the size of the app store and he told me that roughly 70% of the people who land on his website are looking for free apps. GIGaom pegs the number of free downloads to 75% of all downloads based on data obtained by mobile analytics firm Flurry. Using the more conservative 75% number and assuming that downloads for the year 2010 are likely to hit 6 billion, it means that 1.5 billion downloads are for paid apps.

Based on the price distribution from the AppStruck app database, the weighted average price works out to $2.41 per app. The number should probably be lower because more 99 cent apps are likely to be downloaded than apps priced at $99.99. Taking a conservative approach, I am going to put the average price at $2. This means that the Apple app store is likely to generate $3 billion in revenue in 2010 on the low end and $3.61 billion on the high end of the range. Since developers get paid 70% of revenue, we have a potential market size of $2.1 to $2.53 billion available for developers.

AdMob, a mobile advertising company acquired by Google last November for $750 million, was approaching $100 million in gross revenue from advertising. Once you add revenue generated from virtual goods and advertising, the app store ecosystem could begin to approach $3 billion.

Part 2  of this blog entry will cover some of the challenges and opportunities that Glu Mobile faces in this rapidly evolving app store ecosystem.

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Is Toyota Worth Buying at Current Levels?

February 26, 2010 | Stocks | Author Asif

A friend of mine likes to tell a story about how the first car he bought in the 1990s was a brand new Toyota Corolla that stalled in the middle of the 101 freeway in the San Francisco bay area, leaving him feeling very vulnerable and causing him to swear off all Toyota (TM) cars. He has since then purchased a number of cars made by Ford (F) and appears to be happy with them.

I had personally experienced a stalling issue with a new 2000 Toyota Camry that would manifest itself only when I exited a freeway and was stopped at a red light without manually turning the cruise control off. The dealer could not figure out why this was happening and the problem went away after a few months. In contrast I had very good luck with two Fords and still sometimes regret trading in my reliable 35th anniversary Mustang for an IS 350. Both these incidents occurred during a period of time when Toyota enjoyed the unblemished status of being one of the safest car companies and went on to surpass General Motors as the largest car company in the world. With two cars made by Toyota parked in my driveway (the IS 350 is affected by the recall), I have to say that over the years I have been satisfied with the quality and reliability of these cars.

Stalling of a car especially in the middle of a freeway could be dangerous but there is little that can unnerve drivers more than an accelerator pedal that gets stuck or brakes that do not do their job when needed. The situation Toyota faces right now has a number of parallels with the sudden acceleration related issues that Audi ran into in the mid 80s. The company issued a number of recalls and sales suffered as a result of the media attention the case received. It later came to light that there were really no problems with sudden acceleration and that most of the reports related to sudden acceleration had to do with human error. However the damage to Audi was already done and it took Volkswagen’s luxury brand a number of years to recover from this negative publicity. Given Toyota’s global reach and product lines, the impact of these recalls will probably not be felt as deeply at Toyota as they were at Audi.

These recalls and the associated media circus will impact Toyota in a number of ways including,

1. The direct cost of the recalls, which is estimated to range anywhere from $1.1 billion (Toyota’s estimate) to as much as $4 billion (analyst estimates).
2. The intangible impact on Toyota’s brand, which until now was synonymous with quality.
3. Loss of sales estimated at close to $1 billion by the company.
4. The impact on the brand potentially leading to pricing and hence margin pressure in the near term.
5. Defending against individual and class action lawsuits.

Valuation:

Toyota has shed more than $33 billion of its market cap since these recalls began but to ascertain if Toyota looks attractive at these levels, I am comparing several financial and valuation metrics of Toyota versus competitors like Honda and Ford in the tables below. With the acquisition of Jaguar and Land Rover from Ford, India based Tata Motors (TTM) has also become a global player and I have included this SINLetter favorite in the comparison as well.

These car companies are complex entities with operations in many countries and a number of product lines, so simple valuation metrics may not give us the complete picture but they provide a starting point for further analysis.

When you look at some of these valuation metrics, at first glance Ford actually looks more attractive than its peers with a trailing P/E of just 13.7 and a P/S of 0.33. However these numbers mask the fact that Ford’s profits in 2009 were primarily driven by Ford Credit and the automotive division lost money last year. The $132 billion in debt on Ford’s balance sheet is also as a result of Ford Credit and automotive debt at the end of 2009 was “just” $34.3 billion. Ford does expect its automotive division to post a profit in 2010 after excluding special items.

Toyota’s stock is currently trading at very close to book value at a price of $73.90, off 19.48% from its January 19th high of $91.78. In contrast, at the height of the financial crisis, the stock hit a low of $57.68 on March 9, 2009 and fell well below book value. There remains a distinct possibility that Toyota shares still have a ways to fall especially in light of the fact that they don’t exactly look cheap when compared to peers like Ford and Tata Motors. According to some estimates Toyota is losing $500 million in sales each month right now.

Given that the nearly one year old market rally appears to be sputtering and attractive investments are still available in the small cap sector, I would personally hold off on investing in Toyota at this juncture.

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