Almost Longs #1
Stock write-ups are either divided into long or short, but I like to introduce a third category. “almost long”. Stocks I like, but not enough to actually buy them. And giving reasons for not liking them despite being tempted. Stocks that are good to put on a watch list. I think this is more useful because I am not interested in obvious shorts anyway, since I don’t short. But I would like to see why others may not like a cheap looking stock enough to buy, that is in my portfolio.
I will start off with the Embracer group (EMBRAC), since the stock has dropped about 50% recently, which prompted me to take a more serious look at it. I have been into video games on and off in the past 25 years. So this is familiar territory. And while I love games, I think this is mostly a terrible industry for investors. Franchise value is relatively limited and unless you manage to hit the jackpot with a large online game and gain a (weakish) network effect, there isn’t much of a competitive advantage.
As game engines become more powerful, barriers of entry are steadily declining too. Especially with the help of more powerful AI tools it will become easier and easier for smaller studios to make pretty impressive productions. Take for example this game, it was made by 1 guy! On Unreal Engine 4, not 5. And in terms of creativity probably blows a lot of large budget titles out of the water.
Big name franchises also do not protect against failure much if the product isn’t good. Take the latest Battlefield 2042 game. A huge budget production, yet it now only has about an average player count of ~8k because it wasn’t a good game. Team 17 released Hell Let Loose 2 years before Battlefield having no IP in this space and being a virtually unknown small publisher. And it now has a similar and growing player count while only having spent a small fraction of Battlefield’s production budget. But because they created an interesting and new gameplay loop, it drew in enough players to keep the game alive.
That said, the stock does appear cheap at about a 5x FW PE. And despite being the growth segment, video games for console/pc are only just over ⅓ of EBIT.
There are several ways to generate recurring profits in the video game industry. The more ethical way is to create a unique multiplayer concept and draw in a lot of players, like for example the battle royale genre. Having a lot of players online at all times creates a competitive advantage as it will be easy to quickly find a game within your skill level. PUBG has games with 100 players at the same time on a server, and you can find a game within seconds. Their average player count is still impressively high despite being released 6 years ago.
The way to then monetize that is to sell skins with micro transactions. For reasons that elude me there are enough people that will spend serious enough money on cosmetics to make these titles very profitable years after they have been released. But in principle you can play them and have fun without spending a dime since they are often free to play. And they are a nice way to socialise with friends, since there is a lot of downtime. They are not like the old school shooters with constant action.
This is not the same as Facebook’s network effect though. As switching to a new game is far easier. All you need to do is get a few friends to download the new game and you are good to go. So the network effect is rather weak. Especially as competitors come up with a better gameplay loop and manage to get a critical mass of players. And the difference between having an active player base of say 400,000 or 4 million isn’t that meaningful due to diminishing returns.
The less ethical way to recurring profits would be to create mobile games that are a complete grind fest to play. To get faster progress players buy items in microtransactions which do directly affect the gameplay. You don’t buy those items directly though, you buy boxes that could possibly contain those items. A lot of psychological tricks are implemented to get people to keep spending more money on it. Because of how simplistic these games often are, it more resembles a casino game than a video game. And it is nearly impossible to have fun if you do not spend large amounts of money on it. And even if you do, it more resembles a gambling addiction than innocent fun.
About ⅓ of EMBRAC’s profits come from this type of game in their mobile segment. I generally avoid mobile gaming companies as it is impossible to tell how popular a company’s game line up will still be 5-10 years from now. I find it hard to assign a multiple higher than 7-8x to their profit stream. Barriers of entry here are even lower than in the console/pc segment as well. And because of how much this resembles casino gambling I think there will be more regulatory scrutiny on the horizon. There is a strong lollapalooza effect here. A game can generate enormous returns with little investment, but can also rapidly lose its player base again and often does not have the same network effect that large console/pc multiplayer games have. The lollapalooza giveth but also taketh away.
The problem is, most of EMBRAC’s pc/console line up are single player games. And they are a rapidly depreciating asset. Games that are only 2-3 years old often go on 70-80% discount sales and sales plummet after the first few years and only see small peaks during those discount sales. Games that are 5-10 years old are often outdated so that they do not appeal to younger people who have not played them. Unlike movies which hold up better and cannot be created by a single person.
(Because of the lower barriers of entry in the games industry about 5 million games have been made in total, compared to 500,000 movies.)
The exception to this is strategy games or puzzle games where graphics matter a lot less. Like for example Tetris or Starcraft.
Because the revenue trajectory of a single player game follows that of a shale oil/gas well, the way to make recurring profits is to keep churning out a steady stream of well made fresh and unique gaming experiences. This is quite difficult to do as the video game market is highly competitive. Nintendo is quite good at this. Their games often don’t even go on sale. But most studios fail to do this consistently.
EA tried to do it by buying up studios in the 2000’s and 2010’s and was voted the most hated company in America in 2013 because they kept ruining a lot of IP’s with poor sequels. As the talent in those studios often left after the acquisition, they slowly turned into a former shell of themselves. Product people were pushed out and finance/marketing people were given more influence to try and monetise these acquisitions. And technical staff were treated as an expense. Steve Jobs describes this process nicely here. As a result, many of their IPs have been abandoned.
That said, EMBRAC is a more product focussed company with management who seem to be genuinely passionate about games. So I don’t think they will make the same mistakes as EA did a decade ago. And there is a creative bankruptcy currently in the industry among large studios as most of them seem to be in the same part of the cycle described in the Steve Jobs video. With one big project failing after another. So if EMBRAC can pull it together and release a solid line up of quality mid and high budget titles in the coming years, they could do well.
What I don’t like though is that EMBRAC depreciates their development spend, instead of just expending it as a cash expense. This makes it so that Free cash flow is lower than earnings because investment in development assets is significantly higher than the amortisation expense. But how does one determine the useful life of a video game? It would seem more honest if they just expensed this, and it makes me question how real their earnings really are. Since this difference is several billion SEK, impact on profits would be significant if the amortisation expense turns out to be too low.
Then there is also the board game section, which is 26% of EBIT. It seems somewhat of a moat can be had here. Since successful board games of the 80’s and 90’s are still popular. But I am not familiar enough with this to really say much about it. It is a growing market though, and tabletop games are becoming a more popular pastime. But again, low barriers of entry.
Finally EMBRAC has 16bn of net debt. With an EV of 48 billion SEK, and FCF that won’t be more than 3-4bn/year in the coming years and hard to forecast prospects of success with their game line-up it looks somewhat tempting, but not cheap enough for me to buy. Yes on earnings it is cheap, but how real are those earnings?
Hope this was useful to some. If you see obvious mistakes, feel free to point them out. And if you hold this stock, no offense is meant, so don’t take it personal that I criticized this stock. Plan to look at Chinese textile companies next. Tegna and UMDK are also on the list.
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