Long-time readers of The Finance Ghost will know that I’m a fan of the gaming and esports theme. Our lives are going one way and one way only: more digital. The severe lockdowns last year only accelerated this theme.

People were forced to stay home and stay safe. They also needed to stay entertained. It’s perhaps an arbitrary data point, but Telkom now has more households connected to fibre than to copper. In the developing world, broadband access still has plenty of room for growth.

Last week, contributor The Creative Accountant wrote a great piece on the Metaverse, a concept that was discussed by Mark Zuckerberg in the latest Facebook results. Even Satya Nadella from Microsoft reinforced the theme, so it’s worth trying to understand what they are talking about by reading that article here. It isn’t gaming-specific, but rather a nod to how the digitalisation of our lives has only just begun.

Investing in gaming and esports

It’s a challenge figuring out how to play this theme.

For example, companies like Electronic Arts and Activision Blizzard rise and fall based on the games they publish. Tencent is a gaming giant but is filled to the brim with regulatory risk and is anything but a pure-play view on gaming. Sea Ltd is another good example of a mobile gaming company. Unfortunately, the huge valuation multiples reflect that, and I wouldn’t buy Sea at these levels.

My broad exposure to the theme is achieved through specialist ETFs. There are three readily available options ($HERO, $NERD and $ESPO). Their exposure to China varies, which is perhaps the most important differentiator at the moment among the options.

Ironically, I’m not a gamer myself. This doesn’t mean I can’t invest in the industry obviously, but it does make me vulnerable to blind spots as I’m not familiar with all the competitors. That’s primarily why I took the ETF route, as this lets me invest thematically without needing to understand all the competitive nuances.

A Twitter contact (@SebastianGonne3) is a Tesla fan. I’ll forgive him for that, because he also pointed me in the direction of gaming hardware company Corsair $CRSR.

Corsair went public in September 2020 and priced the IPO at $17 per share. It’s now trading at $28 per share.

Selling the shovels

Regardless of what game you play, you need gear. My brother is a pretty serious gamer, and he gave Corsair a glowing recommendation when I asked him about the products. It was like listening to me talk about my love of certain cars.

Webcams, audio enhancers, gaming keyboards, gaming mice, headsets, PC towers and CPU cooling systems all feature in the product range. In the gaming gold rush, Corsair is selling the shovels. New product introductions averaged 3 per week during the latest quarter.

In Q2’19, the company generated $241m in revenue. In Q2’21, that number was $473m, a 40% two-year compound annual growth rate (CAGR). 67% of revenue was generated from the Gaming Components and Systems segment, with the remainder in the Gamer and Creator Peripherals segment.

Here’s an even more impressive data point: gross margin is 870bps higher than it was two years ago. That means gross profit has nearly tripled from $46m to $130m. The margin on Gaming Components and Systems is 23.8% and on Gamer and Creator Peripherals is 35.2%.

Importantly, both segments have substantially increased their gross margins in recent years.

Sounds good. Let’s dig deeper.

If you understand operating leverage and the impact of fixed vs. variable costs, you’ll know that gross profit growth can translate into much higher EBITDA growth. If you aren’t familiar with this concept, read this article once you’re done here.

“Adjusted EBITDA” (is there any other kind in tech?) has shot up from $10m in Q2’19 to $52m in Q2’21.

As is standard in the tech industry at the moment, adjusted EBITDA strips out the effect of stock-based compensation ($7.8m year-to-date, which is material). In simple terms, this is the process of awarding shares to employees either for free or at a discount. The company also strips out intangible asset amortisation.

I would therefore focus on operating income margin on a GAAP basis (the US accounting system), which is 10.2% year-to-date. The adjusted operating income margin is 12.9%. Casually putting 270bps on your margin because of “adjustments” is a trick that all the tech companies use.

Importantly, margins have been impacted by logistics costs and the overall supply chain impact of lockdowns. It’s not unreasonable to expect net margins to improve over the next couple of years.

Corsair is at least cash flow positive (which is more than many tech companies can claim) and has generated $59.4m in cash from operations year-to-date. There’s no “adjusted” nonsense in there, so this is the best number to look at.

$50m of this cash was used to reduce debt, so the company is clearly deleveraging after a period of accelerated growth. Full year guidance is adjusted EBITDA (sigh) of $245 – $265 million and a year-end debt balance of around $90m.

That’s a healthy balance sheet.

Although the company is light on capital expenditure (less than 0.5% of sales), the working capital burden means that the balance sheet looks very different to typical tech companies. Corsair is a manufacturing company that just so happens to be supplying the gaming theme.

The Inventory balance at 30 June was $273m, which means the company achieves annual stock turn of around 7.3 times. Put differently, the entire inventory is sold every 50 days.

Accounts receivable of $258m implies that it takes around 47 days to collect debts from customers. This is because Corsair is supplying distributors around the world.

Net working capital is calculated by deducting trade payables ($262m) from inventory ($273m) and accounts receivable ($258m). Remember, these are balance sheet numbers, so you don’t multiply them by four to achieve an annual number from a quarterly number. This gives us net working capital of around $270m, which is over 13% of annualised sales.

This is why the company needs cash in order to grow.

Cheaper than (the) chips.

It’s critical to look at diluted earnings per share, as this reflects the impact of stock options which aren’t granted to ordinary investors. On a GAAP basis, diluted net income per share for the six months to June 2021 was $0.74. If we annualise this number to $1.50, Corsair’s share price of $28 implies a forward P/E ratio of 18.7x. It’s a forward ratio because we are annualising an existing number rather than using the results of the last four quarters.

The other valuation approach is to use EBITDA. If we assume that genuine EBITDA this year will be around $220m and that net debt will be $90m, then the market cap of $2.6bn implies an EV/EBITDA multiple of 12.2x. You calculate this by adding net debt to the market cap (which gives you Enterprise Value) and then dividing by EBITDA.

Corsair is a real company with real cash flows, so we don’t need to have hypothetical conversations here about total addressable market and revenue multiples.

Nvidia is trading on an annualised P/E of over 65x. AMD is at nearly 50x. Corsair may not be playing in the graphics card or chip industries, but the underlying drivers aren’t that different and it’s trading at a much lower multiple.

At an annualised P/E of 18.7x, I’ll be buying Corsair this week and putting it in the Baby Ghost Thematic Investing drawer. Digitalisation and gamification are trends that nobody should be betting against long-term.

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