7 October 2020
In this note we discuss a number of the key themes in the video games sector, such as consoles, cloud gaming and the potential for lower platform fees. We upgrade FY2 EPS for Frontier Developments and Team17 by 4% and 13%. We downgrade Sumo’s by 5%, though this is due to D&A/share count and currently excludes its recent not-yet-closed acquisition. Frontier, Keywords Studios, and Team17 have had unprecedented equity performances during the pandemic and we will review our target prices and recommendations in due course. The UK names are on 22x NTM EV/EBITDA just below two-year highs.
Industry is booming
It goes without saying that video gaming is bigger now than it was before Covid19. The UK games market was valued at £5.4bn in 2019, down -4.8% YoY, and this trend continued into 2020. However, according to Cardlytics, UK games sales jumped 70%+ during lockdown (mid-March to start of July). In the US, spending in 2Q 20 was up 30% YoY and up 7% QoQ to US$11.6bn, according to NPD. Whilst some momentum slowed in June, play still remains high. The current estimate for the global market in 2021 is US$196bn, according to Newzoo, but we wouldn’t be surprised if there was an upgrade. Although we believe the video games sector will benefit from the lockdown and the Covid-19 environment overall in the long run, the size of the impact is less obvious.
The ‘walled garden’ battle
Epic dropped the gauntlet back in August when it intentionally broke Apple’s rules for its App Store and now we are on the path to potentially both lower commission rates (industry standard c.30%) and the possibility of more power to content owners vs platforms by breaking the control the latter have over content access.
A reminder that the industry is still in its infancy
Video gaming is the largest entertainment sector in the world (US$149bn in 2019). It continues to grow at a decent high single-digit rate, whilst technology (such as PC capability, mobile connectivity and cloud computing) continues to improve. This means investors should consider this sector seriously when allocating capital. Unlike traditional software companies, whose focus is often on upgrades to existing IP, these companies can release upwards of 10 games per year, in addition to upgrades. We believe there is more to come as the sector is relatively immature, albeit some games have reached the age of 50 or thereabouts (eg Pong). Tim Sweeney, founder/CEO of Epic Games, has been instrumental in driving change, including some of the initiatives at Fortnite.
Cloud gaming will change everything, but when?
Cloud gaming promises to liberate current gamers from expensive and clunky hardware, and invite new gamers to play highly immersive games on any device. At a minimum, people will only need a fast and reliable internet connection and a screen. Not only will this benefit gamers, it will also benefit the game industry as a whole, accelerating its already rapid growth. It will be particularly beneficial for developers focused on high performance PCs and consoles. Their games, once limited to those who had access to top-end gaming tech, will now be accessible to the masses. The c.2bn smartphone gamers will also be up for grabs by the traditional console/PC developers, by enabling them to access high quality games on their screens too. This may give mobile developers the notice they need to up their game or risk losing their base. Nevertheless, we aren’t there yet.
FY20: Pushing through model changes
Following the strong FY20 results, we are updating our model. Revenue remains unchanged but FY21/FY22E EPS goes up by 14%/4%, respectively. We also introduce FY23 estimates for the first time. FY21 is looking strong, with two big updates for two of its existing franchises. FY22 will have its first F1 game release and the still-to-be-announced new global IP game. FY23 will have the second iteration of F1 and Warhammer: Age of Sigmar from the IP of Games Workshop#. We recognise the super strength of the equity since the beginning of March (140%) and we will review our target price in due course.
1H 20: Confirming model changes
Following the solid 1H 20 results, we are confirming our model changes made on the day. FY20 revenue increased by 4%, which flowed to an EBITDA upgrade of 4%, but increased D&A sees EPS increase by 1%. FY21 revenue went up by 8% and EBITDA up by 4%, but EPS comes down by 5%. These are before the upgrades that will come once the material acquisition of Pipeworks (announced same day) closes at end of October. Sumo is on 17x CY21 EBITDA versus the other UK names on 22x. As a result, along with the acquisition, we reiterate our Buy recommendation but will review our target price in due course.
1H 20: Confirming model changes
Following the strong 1H 20, we confirm our model changes. Our revenue for FY20 increased by 17%, which flowed through to an EBITDA upgrade of 20% and as a result, we see an EPS upgrade of 21%. For FY21 we are increasing revenue and EBITDA further still, with EPS going up by 13% overall. 2H 20 is heavily new release-weighted, including Neon Abyss, Worms Rumble and The Survivalists, and there remain some known unknowns such as the next generation consoles and the macro environment. We recognise the strength of the equity since the beginning of March (55%) and we will review our target price in due course.