Our companies analyst attempts ‘price discovery’ in a sector that has been over-hyped due to Covid-19.
Video gaming soared during lockdowns – along with spending on home improvements, technology and so on – as people diverted what they would have spent on going out.
Related stocks also enjoyed wider speculation on growth and momentum plays, hence the tendency to 'pricing for perfection’ that left them exposed to the slightest of setbacks.
Searching for fair value after strong run
Frontier Developments (LSE:FDEV), now capitalised at around £1 billion, is a prime example. An initial drop when Covid struck in early 2020, from about £13 a share to £11, was swiftly recovered. The stock rallied to a £34.30 high by last January, which broadly coincided with the peak impact of lockdowns.
The price then drifted down in a volatile channel with lower highs of £32.25 in April, then £28.20 in August; prior to an update yesterday (22 November) the stock was priced at £24.80. That represented a trailing PE multiple of 63x, reducing to near 34x, if the company met expectations for £28 million net profit on £140 million revenue in its current year to next May.
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But after a revenue warning, the stock plunged 37%, paring its loss to 32% at £17.00 later yesterday. Sales have been lower than expected of a latest multi-platform game – Jurassic World Evolution 2 – which it is hoped will become the company’s biggest revenue contributor for the current year. Another key game, Elite Dangerous: Odyssey, has also seen muted sales.
Median annual revenue of £115 million implied
Annual revenue is thus guided in a wide range of £100 million to £130 million, according to sales over Thanksgiving and Christmas. (I am surprised the annual report notes on segmental revenue do not disclose geographic breakdown, but they indicate a strong US element.)
The implied median revenue is an 18% downgrade to recent consensus. £91 million was achieved in 2020-21, so the new median would represent 26% growth relative to a 33% compound annual rate since 2016.
While that does not initially seem enough to warrant a stock slumping by one third, £115 million implies a whopping price/sales ratio of 8.5x at the current de-rated market cap.
Yes, the operating margin is over 20% (see table), but at £17 a share the forward PE may be nearer 50x than 35x based on old forecasts.
Additionally, free cash flow lags earnings because what is generated is re-invested to develop new games. The table shows highly varied free cash flow, which is no basis for a sustained dividend policy. While investors here are motivated by capital growth, there is no yield prop and the valuation suddenly appears exposed.
Warning looks par for the course for gaming companies
You cannot expect linear performance from this sector: sales can be affected by marketing issues and consumer behaviour is unpredictable.
The shock to shareholders is more a moment of truth confirming what the market has suspected in recent months: that Frontier’s value became over-hyped.
The caution over Jurassic World Evolution 2 is rather innocuous, relating only to sales on the PC platform. Apart from teenagers holed up in their bedrooms, you would think current big advances in phone-screen performance would favour mobile devices.
It was explained in terms of a ‘crowded release window’ in the PC sales segment, with various other highly anticipated titles also launching. Otherwise, early sales of Jurassic World Evolution 2 on the various platforms had been encouraging.
Be aware of this industry’s propensity to shuffle assets
If you understand video games quality and appeal, then potentially Frontier’s drop is a buying opportunity. Private equity would surely be deterred by the fickle nature of sales, and also by its weak cash flow profile.
But this industry’s history is strongly characterised by takeovers, and so a reason I pay attention to the drop is that if it continues, a US industry buyer for example could make an approach. It seems a way off, though.
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It was some 20 years ago that Eidos fell from a high rating and was aggressively shorted by hedge funds, which eventually got scalped when the company was taken over in 2005. It was later sold on to a Japanese company in 2009.
All this is outside my preference for some kind of margin of safety in equity investing, and I find it very difficult to judge possible reactions to games. But the pattern of mean reversion in market values is very familiar over the decades: exuberance meets a reality check, which possibly extends to jaundice, followed by genuine value.
Frontier Developments - financial summary
Year end 31 May
|Turnover (£ million)||21.4||37.4||34.2||89.7||76.1||90.7|
|Operating margin (%)||5.8||20.9||8.2||21.6||21.8||22.0|
|Operating profit (£m)||1.2||7.8||2.8||19.4||16.6||19.9|
|Net profit (£m)||1.4||7.7||3.6||18.0||15.9||22|
|Reported EPS (p)||4.1||22.4||9.1||44.7||39.4||53.3|
|Normalised EPS (p)||4.1||22.4||9.1||44.7||39.4||53.3|
|Price/earnings multiple (x)||32|
|Return on capital (%)||5.1||23.5||5.0||25.6||13.0||13.9|
|Operating cashflow/share (p)||-3.6||13.5||25.9||81.5||80.4||96.3|
|Free cashflow/share (p)||-4.6||11.2||-20.1||38.6||26.6||15.1|
|Net debt (£m)||-8.6||-12.6||-24.1||-35.3||-22.2||-20.3|
|Net assets (£m)||22.8||31.3||55.3||74.2||96.7||113|
|Net assets/share (p)||66.8||91.4||143||192||249||288|
Source: historic company REFS and company accounts
Mixed views from the directors in stock trading
The directors’ actions reflect a range of views; but if you are confident in independent directors’ judgement, then take heart.
On 22 October, a non-executive director bought 3,750 shares at £26.67 to own 175,574 shares or nearly 0.5% of those issued. That conveys genuine belief in long-term value; it was not a token purchase by a new non-executive director to comply with expectations.
Quite whether those close to a company appreciate its stock market dynamics is another question. A company’s prospects can look very promising under the bonnet, yet its stock may be overvalued.
Action in stock options conveys a mixed view.
Recently, 34,292 options were granted across three executive directors at an exercise price of £25.40. It is easy to assume that this must mean the board sees long-term value at that price; however, grants happen periodically under the terms of such schemes, which enables directors to face risk/reward differently from outside investors.
A month beforehand, one of those directors – interestingly, the CFO – exercised options on 19,930 shares at a market price of £27.55, thereby raising £543,072, while retaining his 17,000 ordinary shares. That suggests he is alert to protecting gains. Options enable this, while retaining exposure to upside potential when the next slug gets granted.
Around the same time, the chairman sold 10,000 shares at £27.00 while retaining 280,000.
It will be interesting to see if and when any of the directors or senior managers wade in to buy. With the revenue narrative suddenly altering, however, one is reminded of the old Greek proverb: “You can never step in the same river twice.”
Operational gearing may imply EPS prospects have nearly halved
In the short term at least, revenue disappointments can impact profits more, so I am not surprised by one 2022 EPS forecast revision to 35p compared with 63p previously.
I suspect buying for recovery will be muted overall until the Christmas trading results are known, at least. Will they affirm suspicions or knock them for six? Without deep knowledge of the gaming industry, I find it pure speculation. Even the directors’ views on equity value seem mixed.
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With fresh money, I would therefore sit back – aware that if the story worsens in January (an update came on the 13th this year) then short sellers may start playing their own games.
Possible interest rate rises are also liable to affect over-valued growth stocks worse than others. Despite Frontier’s drop, its ratios remain rich.
But shareholders can take some heart: a mercurial games industry means revenue fears may yet prove temporary, in which case for them: Hold.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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