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Aton
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Articles 

Contest: I Got Games - Fast-Grower at Cheap Price

Mr. Market is feeling depressed about this healthy cash-generating business due to temporary factors

November 09, 2018 | About:

I don't like mobile games. Especially online games. They consume a lot of time (you are not going to make any progress otherwise), they are process-oriented and after hundreds of hours spent in the game and thousands of tasks accomplished, your beloved character will be destroyed in a second by a child who asked his dad to give him a few dollars to play.

But, I certainly would like to be on the other side of the game. Many students dreaming of becoming rich stop for a while to think of writing a program code for a game, and it is not a foolish thing to do. It takes no capital to speak of (almost all property is intellectual), the market is huge and growing, the product can be easily differentiated (by the plot or idea -- again, not a physical asset) and you are getting paid per download (and there are advertising opportunities in some cases). These features mean it is not very difficult to monetize an idea.

So companies that have any significant presence in the gaming field frequently experience high margins, low capex and, subsequently, attractive returns on capital. That is exactly the case of IGG Inc. (OTCPK:IGGGF).

History and business

I Got Games is a Singapore-based developer and publisher of mobile games with global presence and international customer base counting approximately 550 million registered players globally, with total monthly active users (MAUs) of over 22 million. As of June 30, 47% of the group's revenue was generated from Asia, 27% from North America and 22% from Europe. Revenue from mobile games was over 99% of total revenue.

IGG was founded by Zongjian Cai (also the founder of popular gaming website 17173.com) in 2005 with only one game in the pipeline at the time, MythWar Online. The company has released new games almost every year since then, but the real contributor to IGG's success was Lords Mobile, a real-time war strategy game released in March 2016.

It is now responsible for 80% of the group's revenue despite not being No. 1 in terms of registered users. The game won a number of awards, including the "Android Excellence Game of 2017" awarded by Google Play, and generated more than $440 million Hong Kong dollars monthly average gross billing revenue on 130 million users in the first half of 2018. (Go here for more information on the group's history and current positioning.)

IGG uses F2P (free-to-play) business model, which is a pure play on human psychology. There are no barriers to entry the game space and can do that in a few clicks. Most people start playing just "to see what happens." In the first few weeks, the new user achieves quick success, and that is the point where addiction appears. Everyone likes to be successful. At some point, it becomes impossible to maintain "the growth rate" of a character without access to additional perks for which you have to pay. But this option demands only tiny sums of money. It is so cheap that many players start paying only "to see what happens" again. They pay not for the game but, one, for the feeling of success and, two, for the fear of losing of what has been achieved before.

(As in the case of corporate borrowing, nobody takes on debt in order to get bankrupt. Oftentimes it is impossibility of organic growth combined with the cheap option to sustain the growth story.)

Financials

A quick look at financial metrics suggests the model is working quite well for IGG. Current operating margin (using 2017 full-year and 2018 first-half numbers) is nearing 30%, net margin is 25% and ROTA (return on tangible assets -- one of the most useful tools to determine business quality) is above 50%.

Metric

Current

Median

5-y average

Operating margin

29.5%

24.7%

24%

Net margin

25.7%

21.5%

21.8%

ROE

68.5%

35.4%

33.6%

ROTA

49.2%

29.9%

26.7%

Growth rates are quite impressive too:

Metric

Full Y/Y

4-y CAGR*

Revenue

88.5%

43.7%

EBIT

131.6%

35.7%

Net income

114.9%

33%

FCF

144.3%

35.4%

*Taking 2013 and earlier years as a base gives ridiculously high numbers because of the low base effect.

The next tables shows that growth was not achieved at all costs. Asset turnover ratio was actually rising (which means asset growth has not been outpacing revenue growth) and free cash flow was larger than reported net income most of the time (this indicates high earnings quality).

 

2013

2014

2015

2016

2017

FCF

17518

68496

49425

69522

169866

FCF/net income

2.52

1.03

1.19

0.96

1.09

Asset turnover

0.58

0.94

0.92

1.33

1.92

Regarding balance sheet strength, well, IGG has no debt. As of June 30, long-term liabilities include only $409,000 in deferred tax obligations. All other liabilities are current at $109.39 million (including $30.91 million in deferred revenue, which will eventually go to the income statement). They are well covered by $282.48 million in cash and cash equivalents (of which $271.61 million is cash at bank and in hand).

I know, I know. There are off-balance sheet ways to finance operations. But the company has only $9.42 million in operating leases (mostly property leases). It is safe to say that IGG is not going to go bankrupt in the near future.

Management

Zongjian Cai, the founder of the company, is still serving as CEO. However, the management team was completely renewed with no top executive appointed earlier than August 2015.

Insiders own more than 30% of the enterprise, but I would not say with certainty that this fact aligns management's interests with shareholders. Many shares were acquired long ago through an extensive option scheme with very low strike prices for options. Executives are not going to suffer losses anyway in the current situation (but, it is unclear regarding new board members. It is possible that the cause for renewal was lack of motivation for previous executives).

Capital allocation skills are satisfactory considering share buybacks, dividends and no signs of "diworsification." With very low capex needs (just 0.5% of assets), management consistently invests in the high-margin core business, keeping most expense-to-revenue ratios constant and gradually raising R&D (new games development) and advertising expenses. What is more important is that the company has enough resources to grow through M&A, but there are no expensive acquisitions in place (almost all purchased assets are PP&E with no ballooning "goodwill" charge).

IGG paid 30% of net income in dividends and bought back approximately 2.8% of market cap in the first half of 2018. The company was issuing shares until 2015 and is a net buyer since then. All mentioned above is no proof of high capital allocation skills but, from my view, it is a hint that managers are at least trying to think like owners (and they are ones) and make rational decisions based on current circumstances rather than on static formulas or the intention to keep the share price as high as possible every day.

Valuation

How much is IGG worth? Let's go through some well-known steps to determine that.

First, liquidation value analysis is not appropriate here since the company is unlikely to be liquidated and investors are unlikely to get any liquidation proceeds from a Singapore-based company. Liquidation value is certainly positive, but that means nothing in practice.

Second, IGG's assets must be worth more than their tangible book value because the company earns more than 50% return on them. At this point we have to get to comparisons (ratio analysis).

Metric

Current

Historical average

Industry average

P/E

8

16

28

EV/EBIT

5

11

19.9

P/B

5.3

5.7

5.8

P/S

2.4

3.5

6.6

Results are mixed with undervaluation ranging from 75% to just 9%, but IGG doesn't look overvalued in any comparison, which is a good sign.

Finally, the DCF analysis. Above all, intrinsic value is the sum of discounted cash flows that can be taken out of the business during its remaining life. It is always an estimate (and a "bad information," as professor Joel Greenblatt says), but in the case of IGG calculations are quite simple.

The group's market cap is $1.41 billion at the time of writing. Enterprise value is $1.13 billion. As seen previously, free cash flow is close to the net income figure, meaning we can use the latter as a base. IGG already earned $98.4 million in the first half of 2018. Second-half profits are usually higher, but just earning the same in the remainder of the year brings us to $196.8 million in 2018 net income figure. Assuming a quite conservative 10% discount rate and no growth (and also no deterioration) in the future, business value is obviously $1.968 billion, which implies a 28% gap between price and value (43.6% regarding enterprise value).

However, it is reasonable to assume at least modest growth of earnings per share caused by new projects, geographic diversification (I will talk about these issues a bit later), rising market and buybacks. Below is a conservative model with revenue growth equal to estimated gaming industry growth through 2022 (9.3% CAGR), no growth after that and an immediate reversion of margins to the mean (with 2018 net income lower than 2017 number as a subsequence).

Year

2018

2019

2020

2021

2022

Revenue

663727,53

725454,2

792921,4

866663,12

947262,79

EBIT

159370,18

174191,6

190391,4

208097,83

227450,93

Net income

143433,16

156772,4

170400,3

186247,56

203568,58

Year №

1

2

3

4

5

Discounted cash flow

130393,78

129564

128024,3

127209,59

126400,07

Sum of DCFs

641591,74

       

Terminal value

2035685,8

       

Discounted TV

1264000,7

       

Intrinsic value

1905592,5

       

Market cap/Value

0,74

       

EV/Value

0,59

       

This scenario implies fair value of approximately $1.44 per share. More optimistic (but still reasonable) assumptions give numbers north of $2.

So how much is it worth? More than Mr. Market offers today will be the correct answer.

Risks

There are many risks out there (IGG is no Berkshire Hathaway), but the most serious are that it's all a fraud and possible overexposure to the Asian market.

Considering risk No. 1, well, surely it is higher than with U.S. companies. It is impossible to know exactly, but I found no red flags in the accounting documents. No mounting receivables, intangible assets, strange reserves, indefinable notes or misstatements. The only weak spot is "deferred revenue" figures (and primary concern for the auditor, KPMG) but the numbers (again, if accurately reported) are insignificant to income statement.

Regarding risk No. 2, why on earth am I not talking about the game approval freeze in China that sent Tencent shares in a nosedive? This is a direct and uncertain risk for IGG's business. Nevertheless, the situation is not catastrophic and even may be a positive.

First, the freeze applies to new approvals only and does not ban already-approved games. We already made calculations assuming no expansion of the current pipeline. Second, the freeze is temporary and though it will have some impact on current results, the decision is going to come in some form.

Third, over half of IGG's revenue is generated in non-Asia regions, and this fact still leaves some room for continued growth. And finally, the freeze is going to put small market participants out of business and ease the degree of competition. (You may read additional information on the issue here.)

Outlook

There is no need to repeat all the thoughts mentioned above. IGG is a good business generating much cash, which managers (owning more than 30% of the business) consistently deploy to new game developments, advertising and employment of new talented workers. They also return capital to shareholders through share buybacks and dividends.

With five new projects in progress (that will reduce the overexposure to one cash cow, Lords Mobile), it is rational to assume at least modest future growth, though not as rapid as in the past. With current valuation implying significant deterioration of this healthy, debt-free business, IGG is a sound investment from the risk/reward standpoint.

Disclosure: I have no positions in the stock(s) mentioned.

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About the author:

Aton
I work for the only company in my country that uses value investing principles, Aton. I work as a junior portfolio manager at one of the company's regional partners and dream of building a value investing fortress here.

Rating: 5.0/5 (2 votes)

Voters:

Comments

teikhooi
Teikhooi premium member - 6 days ago

Risk would be the single game only sells well. If it is multiple games will be great

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