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Friday, June 26, 1998
Midway Games Inc.
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Phone: 773-961-2222
Website: http://www.midway.com
Price (6/25/98): $13 5/16
HOW DID IT FIND TROUBLE?
A burdensome spin-off. A fiscal shortfall. These are the monsters of the Midway <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MWY)") else Response.Write("(NYSE: MWY)") end if %>. Like Mortal Kombat, the company's best-selling coin-operated arcade game, the blows have come relentlessly for the video game specialist over the last three months.
In March, the company shocked Wall Street when it pre-announced that earnings for the quarter would come in at about $0.18 a share, well below the quarter a share that the analysts were expecting.
Bad news came again a couple of months later when the company had to pre-announce that earnings for the June quarter would be soft as well. This time? A quarter a share, but well below the $0.29 a share the company had earned the year before.
These two quarterly disappointments would probably not have caused a serious decline in shares that were seemingly cheap to begin with. However, this time there was a deluge in between. Like collapsible bookends, the two pre-announcements encircled the April spin-off from WMS Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMS)") else Response.Write("(NYSE: WMS)") end if %> of its remaining 86.7% stake in Midway.
The shares were distributed to shareholders of WMS, the parent company that dabbled in everything from pinball to video chance games, but it was poor timing. With Midway in a fundamental rut, it was easy to see why investors' knee-jerk reaction was to sell.
BUSINESS DESCRIPTION
Midway Games produces video games for the arcade, personal computer, and home console markets. From the popular Mortal Kombat to the high-tech Area 51, to the entire catalog of Atari Games classics, the Chicago-based company is a leader in the leisure video gaming market. Over the past year, Midway's leading segment has gone from the coin-operated games to the consumer home-based software titles.
The company came public in November of 1996 when WMS -- in a move to increase shareholder value by shedding assets, including a few choice hotel casino properties in Puerto Rico -- sold 5 million shares of Midway for $20 a share.
FINANCIAL FACTS
Income Statement
12-month sales: $391.2 million
12-month income: $43.9 million*
12-month EPS: $1.15*
Profit Margin: 11.2%
Market Cap: $512.5 million
(*Excludes one-time gain)
Balance Sheet
Cash: $33.8 million
Current Assets: $176.1 million
Current Liabilities: $64.2 million
Long-term Debt: None
Ratios
Price-to-earnings: 11.6
Price-to-sales: 1.3
HOW COULD YOU HAVE SEEN IT COMING?
How do you sink a float? The answer lies here, in the April spin-off. Fundamentally, everything was exactly the same. The company had the same 38.5 million shares outstanding before and after the distribution. Yet the 27.9 million shares that WMS ultimately handed out went from being practically frozen in the WMS coffers into the more finicky hands of institutional and individual investors.
Once the shares were transferred, there were two types of sellers. Big money arbitrage specialists, and even some playing at home, had taken to the spread of the deal. WMS was to distribute 1.2 shares of Midway to every shareholder. Most figured that the smaller WMS shell left behind would be worth about $5 a share. At the time, the shares of WMS were trading at a discount to the value of Midway and the eventual remains of WMS.
Professional arbs could have locked into the spread by shorting Midway and buying WMS. Then, once the deal was completed, close out all three positions (selling the new Midway shares, selling WMS, and covering the original Midway short sale). While that was a zero sum game, those who chose a less conventional arbitrage play -- to simply buy WMS and cash out of both stocks after the distribution -- flooded the supply of shares.
Then we have the second type of seller -- the one who may have been a long-term investor in WMS because of Midway, but wanted to bolt after seeing the March pre-announcement. Instead, they waited. Rather than sell the discounted WMS shares in March, these investors figured they could sell the premium-priced pieces come April.
In the end it was those who hung on who lost. When the natural volume explosion after a spin-off has an unusually bearish burden, it is easy to see how things will end badly.
WHERE TO FROM HERE?
All this and we have yet to consider that this is a bona fide value, rocked by market mechanics. With the pre-announcement we already know that fiscal 1998 is bound to come in at about $1.20 a share. Analysts are looking for $1.35 a share next year. At 11 times trailing earnings and 10 times year-ahead earnings, there seems to be a good opportunity here for an asset-rich, debt-free company.
The company has been making major headway in the home console market, as Nintendo 64 and Sony PlayStation continue to be blockbuster industry platforms. While the company was already a leading game cartridge provider for Nintendo 64, fiscal 1998 finds the company ramping up the title count for not only Sony PlayStation but also for the resilient Nintendo Game Boy and the potentially explosive personal computer market. Even the coin-operated market, which has suffered in large part due to the great quality of home consoles, is getting a Midway boost. While sales had been off 25% in the token-swallowing niche, the company is still committed to the video arcade segment and will release 11 new games as opposed to the 8 it delivered in fiscal 1998.
With the June 29 release of Mortal Kombat 4 and the company excited over NFL Blitz (despite the already established gridiron standards in Acclaim's NFL Quarterback Club and EA Sports' Madden Football), there is good reason to be optimistic here despite the floundering share price. With earnings expected to rise once again and the sellers seemingly done selling, the potential upside is compelling -- and may make your next coin a token well spent.
-Rick Aristotle Munarriz
([email protected])
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