Small-Cap Spotlight: GigaMedia Worth the Gamble

The online gaming name offers real opportunity here.
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In this week's Small-Cap Spotlight, Frank and Larsen dig into GigaMedia (GIGM) - Get Report, a Taiwan-based provider of real money gaming software and online games.

Larsen: Short-Term Volatile; Long-Term Win

Don't get me wrong, the business of online gaming, particularly online gambling, is a far cry from a traditional industry. But U.S. investors seem overly skeptical toward GigaMedia, a company whose success relies heavily on online gambling, an activity that's illegal in this country.

When looking at GigaMedia, small-cap investors should set aside those ingrained prejudices and accept the fact that online gambling is far more accepted on an international scale, and therefore a company like GigaMedia, which operates across Asia and Europe, offers a unique investment opportunity.

The company's primary long-term driver is the Everest Poker product, which analysts say is a top-five online gaming poker site in terms of traffic. Everest Poker is on track to almost triple its revenue in 2007, following up a 144% growth rate in 2006.

Analysts at Bear Stearns, which initiated coverage of GigaMedia less than two months ago, see Everest Poker's revenue growth stabilizing in the 20% to 30% range over the next three years, with 2008 revenue expected to hit $117 million. This relatively slower rate of growth could provide a catalyst if the company beats expectations over the next year.

Small-Cap Spotlight: GigaMedia Gets the Green Light

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In addition to its poker business, GigaMedia has a diverse stable of non-gambling games -- FunTown, FreeStyle and Hellgate: London, a first-person shooter-style role-playing game, which is actually a MMORPG (massively multiplayer online role-playing game) -- that established communities of gamers but have yet to show the potential for the same large financial returns as Everest Poker. These games have the potential for additional revenue generation as GigaMedia leverages their popularity and strong user communities.

On the fee side, GigaMedia has received the right to operate Holic, a cutesy fantasy online game with colorful environments where player can complete quests. Earlier this year, the company purchased the rights to operate both of these games for a license fee and running royalty fees in the low 20% area.

Shares of GigaMedia have been extremely volatile over the past six months, mainly due to the speculative nature of the name and the far-from-certain future growth rate. Shares enjoyed a strong run to $25 from $10 from August to November, as the investment community became more aware of the company's significant potential.

Clearly a momentum play during that period, the stock suffered a brutal selloff when its momentum-based strength faded in early November, with shares plummeting more than 30% in less than two weeks. Since then shares have stabilized somewhat, due in part to third-quarter results released Nov. 14 that were ahead of consensus estimates.

Recently trading around $18, shares of GigaMedia are an attractive speculative play for investors looking for a foreign small-cap play that offers big upside. On a price/earnings basis, the stock is very reasonable, trading at 19 times 2008 consensus estimates (currently 94 cents a share). Keep in mind that earnings are expected to grow more than 40% next year, and the company has zero long-term debt on its balance sheet.

I expect Everest Poker to provide the stable and predicable revenue growth that analysts are currently expecting, while GigaMedia's other online games offer significant potential if they secure a major following. Success on both those fronts should create opportunity for increased fees and a higher rate of growth in the coming years. Increased analyst coverage could also prove to be a catalyst for investors, as Bear Stearns is the only major Wall Street name to have initiated coverage up to this point.

Frank: Pullback Creates Buying Opportunity

GigaMedia has almost every quality you want in a small-cap stock. The company has huge growth potential from its two major divisions, several catalysts heading into next year and a strong balance sheet. Add in the international exposure and the fact that shares have pulled back 25% from their November high, and I believe the stock is a buy here.

GigaMedia's gaming software segment accounted for almost 70% of the total revenue last quarter, primarily through Everest Poker. The segment is a huge growth driver, as operating margins from poker are 32.5% and it delivered 162% year over year, led by an increase of over 50,000 new players over the last three months.

The strength of these results surprised some, as management said on the latest conference call that the third quarter is seasonally weak. People play less poker online during warmer months and more during the colder months, and while the current quarter will likely include colder weather in the company's target market, we could see an earnings beat that drives a good short-term trade.

Some may question the legal implications of this division given the recent ban of online poker in the U.S., but GigaMedia's operations are in the European markets. Thus far, the E.U. and the World Trade Organization has expressed interest in regulating and licensing the industry and a ban seems to be off the table.

Looking at GigaMedia's casual game segment, revenue increased almost 40% to $10 million from the last comparable period. However, margins decreased significantly to 23.3% from 26.7% last year, mostly due to the consolidation of T2CN, an online games operator based in Shanghai, China.

But this move appears to be only a temporary setback as its T2CN division gives GigaMedia the rights to operate some of its online games in China, which offers more than four times the expected growth offered in its primary market of Taiwan, according to estimates in a Bear Stearns research note. This will open up a significant future revenue opportunity for the company.

As mentioned above, the stock price has fallen 25% over the past month and this could be contributed to the delayed release of its Hellgate: London game in China which has been delayed to the second or third quarter of next year from a planned first-quarter release. Also, management announced that it has delayed the launch date for its real money Japanese games to the first quarter.

While delays are disappointing, usually they turn out to be great buying opportunities as this business will eventually come on stream, just at a later date. One only needs to look at the delays in

Microsoft's

(MSFT) - Get Report

Vista operating system, which would have given investors the opportunity to purchase the stock in the mid to low $20's just weeks following its announcement back in March 2006.

Based on the catalysts mentioned above, shares have 20%-plus upside potential. Also, the downside risk seems limited, given the company's strong balance sheet. I would use the recent pullback as a buying opportunity.

Have a small-cap you'd like to see covered? Email Curzio and Kusick.