Stockwatch: a red-hot sector, risk and opportunism

A possible takeover has put a rocket under this share, but it tells us a lot about this boom industry.

Why are enough hedge funds accumulating shares in AIM-listed video games developer Codemasters Group (LSE:CDM) – taking its share price to over 500p versus an indicated 485p recommended offer from Take-Two Interactive Software Inc (NASDAQ:TTWO)? 

Does the balance of probability suggest further upside by way of a rival offer, or does all this signal how speculative the market has become? 

Only a week ago, I examined a similar majority-paper offer by media group Future (LSE:FUTR) for price comparison website group GoCo (LSE:GOCO), querying if partly symptomatic of exuberant times. This latest deal is a similar one of higher-rated equity being exchange for relatively lower, which helps to boost the acquirer’s earnings per share (EPS). Such managers are embracing risk and being opportunistic.

Questionable aspects about this deal 

The shares-and-cash offer was barely any premium over market price when first announced in early November, and there do not appear signs of irrevocable acceptances among key institutions beyond Codemasters directors, who were probably given assurances about their future during negotiations. 

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Granted, the stock rose from 360p in early October, but this followed a 7 October trading update for the half-year to 30 September: like-for-like revenue nearly doubled to £80.5 million and adjusted operating profit of £21 million versus £9.4 million in the first half. Possibly this was an exceptional phase when gamers had time during lockdown, as shown by digital sales rising from 62% to 73%. However, Codemasters is a fundamentally high-margin business with no debt and net cash of £49.8 million relative to the deal valuing the group at £739 million.  

‘Independent’ directors will profit short-term 

All the non-executive directors at Codemasters enjoy share options, an arrangement declared unacceptable in the 1992 Cadbury Report that originally defined corporate governance. Indeed, the one who chairs the board remuneration committee, appointed only last April, is in line for well over half a million pounds worth. Cynics might say it exemplifies why you should be wary of companies listed on the lighter-regulated AIM market, but the aim (forgive the pun) of the Cadbury Report was universal.

A deal would still require 75% shareholder approval, so it is not as if control has ultimately been ceded to a cabal. From a behavioural angle though, what would hedge funds accumulating equity off, say Slater Investments, which has cut its stake from 9% to 6%, gain by blocking the deal? The price would retreat in the short term, hence, on such a timescale the only rationale is to flush out a rival bidder.  

An initial city view was sceptical of the deal's terms 

Panmure Gordon, a broker with no commercial links to Codemasters, hence independent, opined that after stripping out the cash balance the exit-price/earnings (PE) ratio was around 20x based on the 485p offer price. But they thought “the likelihood of additional upgrades is extremely high”. 

After revenue doubled in the first half-year, consensus is for only 10% in the second half, year-on-year. Moreover, the driver (hence attraction) of Codemasters is the ongoing shift to digital distribution which could boost operating margins by over 10%, Panmure argued.

“In our view, these factors, let alone an attractive bid premium, do not seem to be fully captured in the proposed offer.” 

By way of peer comparison, a benchmark video gaming exchange-traded fund trades on a circa 34x PE, albeit lower than the 56x for Frontier Developments (LSE:FDEV)and 54x for Team17 (LSE:TM17).

Moreover, Take-Two appears to be gaining synergies, according to its expressed rationale about how the Codemasters deal can “leverage global distribution also core operating expertise in publishing, live operations, product development, brand and performance marketing”. Unless symptomatic of bull market euphoria, this also implies more by way of bid premium as warranted. 

Are high values due to a few winning games and ultra-low interest rates? 

The reason I did not pick up on Codemasters earlier is likely because I am a tad long in the tooth regarding video gaming stocks. I can recall past boom-and-busts, for example, when Eidos became a city favourite, only later to be aggressively shorted with claims it would go bust. Similarly, until a year or two ago, these stocks were out of favour then roared into fashion on the back of various booming games (I concede, nearing the age of 57, I may not be the best judge to anticipate). 

Gaming development has coincided with soaring PE’s on growth stocks, pushed higher by central banks’ demolishing interest rates further in response to Covid-19. Bulls argue this is justified by growth companies’ better long-term prospects and the elite few – such as the US FAANG tech stocks also selective technology plays like we see here – warrant a premium for scarcity.  

Yet interest rates are low because major economies are mired. Think also how might rising unemployment, plus inevitable tax rises to pay for furlough schemes and other Covid emergency measures, bear on discretionary spending? Supposedly, the young are most at risk in the wake of Covid and would appear the main consumers of such games.

Both companies are motivated to huddle together  

The environment for developers may be high risk as well as potentially high reward, hence I can see both sets of directors may feel a sense of security in combining operations. 

Take-Two is capitalised at around $21 billion (£15.6 billion) versus £768 million for Codemasters, and a 73%-weighted paper offer of Take-Two equity on a PE in the mid-40s, should reduce the financial risk for the acquirer – if Panmure is correct to argue Codemasters’ is more like 20x. Merger risk is left chiefly one of integration, especially if key talent moves on. 

Behaviourally, the Codemasters bosses may reckon it astute in their interests, to cash in equity/options at this level – exchanged for new incentives and assured roles in the enlarged group.  

Codemasters stock has crept up inexorably in the last month

This morning, Codemasters shares initially rose 1.6% to 516p, another record high. 

Among hedge funds adding to their stakes above the 485p offer price are Odey Asset Management, up from 1.5% to 2.6% and Sand Grove Capital from 4.6% to 6%, notably buying over 1 million shares around 506p. Odey's latest increase appears to be a contract-for-difference (CFD) bet.

Yet Slater Investments has used the last month’s strength to trim its stake from 9.3% to 6% - as if sceptical to push its luck further. Such a judgement includes the upshot of potentially accepting Take-Two paper. On a technical view, many UK investors may be averse to doing so: individuals if their broker nominee accounts do not facilitate this, and fund managers if having a remit for UK equities only. I suspect these will sell Codemasters in the London market if the deal is passed. 

Take-Two is also a classic example of near-parabolic US Nasdaq stock, from $8 in 2012 then turning highly volatile in a sideways trend from 2017. It has soared over 40% this year despite a March plunge when Covid-19 triggered lockdowns. Yet its revenue and profit growth are around 20% levels for its last financial year, which on the basis of an historic PE in the mid-40s, implies a PEG ratio (price/earnings-to-growth) over 2.0 – very expensive, even if PEGs properly take a forward view.  

Simple though PEGs can appear, and make many Nasdaq stocks grossly over-valued, the late Jim Slater would have preferred growth stocks on PEGs of 1.0 or lower – and only in exceptional cases tolerate up to 1.5x. (As described in his “Zulu Principle” book from the 1990s.) 

Take-Two’s big revenue gains are from the pandemic  

Take-Two’s first-half to end-September showed net income up 59% to $188 million but, remarkably, it appears to have guided for revenue to stay flat for its March 2021 fiscal year overall, and net income to ease 4%. Next year, the consensus of Wall Street analysts expects revenue and earnings to grow 5% and 1% respectively. That implies a hugely expensive PEG ratio.

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I am therefore not surprised how Slater-the-younger has trimmed his fund’s risk exposure, especially if a £70 million stake in one company represented high "specific risk" (i.e. a concentrated position).   

All-considered, I would be wary to accept and hold Take-Two paper, the neatest way forward here for individual holders is to sell in the market than get greedy. Hedge funds betting on a higher takeover are very well capitalised to accommodate losses.  

It is a sign of bull market optimism how company managers and financial traders want to chase such a combine. Who knows, for how long such animal spirits may last. If the deal does not achieve 75% acceptances the price will drop. My stance is conservative: Sell. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.