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The following segment was excerpted from this fund letter.
“My experience is that difficult times create the greatest opportunities.”
– Lars Wingefors, CEO Embracer Group[1]
Embracer Group (Embracer) has completed more than 80 acquisitions since its IPO in 2016. The company spent more than $10bn on these acquisitions altogether. In addition, Embracer spent close to $1bn on game development projects. Thus, the group invested more than $11bn over the last six years. However, at today’s stock price, the market values the enterprise at around $8bn.
Either the market massively undervalues Embracer Group, or CEO Lars Wingefors managed to destroy 30% of the invested capital over the last six years. Which is true?
Acquisition multiples of operative units (including undiscounted out-year earnouts) average around 10times EV/EBIT. Acquired IPs include evergreens such as The Lord of the Rings, Tomb Raider, or Sudoku.com. The operating groups grew EBIT at 32% since joining Embracer. Older acquisitions can be well assessed today. For instance, Coffee Stain: acquired for $100m in 2018, sold more than $200m of the game Valheim alone. Milestone: acquired for $90m in 2019, sold about 1.5 million units of the premium game (price $49.99) Hot Wheels Unleashed within the last year alone[2], not counting sales of the 71(!!) DLCs. High returns on the purchase prices of almost all acquisitions that closed more than two years ago are obvious.
Embracer’s average return on new game releases is about 3-times the investment.[3] For recent games, however, that average has dropped. AAA-game Saint’s Row, Embracer’s most expensive development to date, was a disappointment. Acquisitions made over the last two years have had higher price tags and are harder to judge. For instance, the Western studios of Square Enix were bought in August for $300m but are not expected to contribute any profits over the following two years[4].
Uncertainty regarding the newer acquisitions, performance of recent releases, and doubts about synergies in Embracer’s decentralized model led short-sighted shareholders to sell Embracer’s stock.
SHARING THOUGHTS: NORDSTERN CAPITAL in conversation with Lars Wingefors, CEO at Embracer Group:
Acquisitions:
Every acquisition has a business plan and assumptions about future cash flows. Execution is continuously evaluated regarding the plan and the capex invested.
Embracer acquires businesses based on their stand-alone cashflows, not based on future synergies. Embracer did not pay premium for IP rights (except for The Lord of the Rings). For instance, Dark Horse came with hundreds of IPs and has a lot of additional potential upside from transmedia, guidebooks, etc. However, the purchase price for Dark Horse was based on a reasonable multiple of the current cash flow.
Allocating $3bn to acquire Asmodee and putting debt on the balance sheet increased the group’s overall business risk. In hindsight timing might not have been optimal.
Lars Wingefors refuses to account for any potential synergies in valuing deals, however, he does believe that there is added value in leveraging the combined group. The verdict is still out. If Embracer were to fail to deliver on that promise, then shareholders might have to discuss in the future whether breaking up the group or selling assets would create higher value.
So far, in general, acquisitions are performing according to expectations.
Performance:
Certain studios have been underperforming. There are various options, for instance a change in management, putting labels together, reducing capital allocation. Capital allocation needs to be based on performance.
Embracer needs to ensure that companies, particularly those that have tighter margins and higher cost bases, safeguard their margins.
Embracer promised earnouts based on organic growth. If studios don’t deliver, then the group will claw back equity. If a team of people cannot make money, then the group will make adjustments.
Synergies:
One of the strategic reasons to acquire all these IPs and assets is the belief that the combined pipeline of games is worth something for other stakeholders and platforms.
There is value in securing an amount of content for the coming years. If Embracer were to sign 15% of the industry’s content to one customer, then that would be a problem for the other platforms.
Embracer is in a unique position and can sign a lot of titles. Platforms might pay premium for the average outcome of such a pipeline.
A platform deal with one or several parties could mean for Embracer: higher margins, more predictable cash flows, greater profitability, lower capex and more revenues.
Embracer is targeting to release 110 new PC/console games this financial year, has a pipeline of 222 PC/console games in development, has an unprecedented depth and breadth in the video games industry, is currently operating more than a dozen franchises that return more than 5-times the invested capital, and has a history of exceptionally successful acquisitions.
Embracer has 1,235 million shares outstanding, 1,343 million if the maximum potential future earnouts and all recent acquisitions are included. The company has about $2bn in debt at 1% annual interest rate[5]. Compare this rate with the junk of so-called “unprofitable tech” companies. Telling. Embracer’s net debt is about $2.3bn, including future cash earnouts and all recent acquisitions.
Embracer provided EBIT forecasts for the next two financial years. The company targets to return to a net debt/EBIT ratio of less than one. Thus, some free cash flow will probably be used for debt reduction. Embracer’s game development investments over the last eight quarters average three times the game development amortization expense. We estimate that maintenance capex for the PC/console segment is approximately equal to the game development amortization expense.
To value Embracer we use the maximum dilutive share count and assume that 50% of the free cash flow over the next three years will be used for debt reduction (and 33% for “maintenance capex”, and 17% for “growth capex”). The company is releasing two AAA-games in the current financial year. Embracer is expected to release an average of at least eight AAA-games per year (!!) in the following years in order to reach the stated goal of “over 25 AAA-titles until March 2026”[6]. This pipeline indicates substantial long term organic growth. For the financial year 2025, we use the company’s EBIT forecasts for recent acquisitions and 13% EBIT growth over FY2024 for the rest of the group.
Embracer Group valuation: Enterprise Value to operational EBIT
|
@53SEK per share |
March 2023 |
March 2024 |
March 2025 |
|
EV / EBIT |
8x |
7x |
5x |
|
EBIT growth |
25% |
20% |
|
Embracer Group forecasts and Nordstern Capital estimates. |
Embracer is expected to continue double digit organic growth. Management expects to keep taking market share in the video games industry. Embracer’s share price today values this cash flow machine 2.5 years out at 5-times EV/EBIT. We are buyers.
However, we won’t be the only ones. Before this year is out, Embracer is expected to up-list to the main Swedish stock market. This will bring new buyers. Several funds are restricted from buying Embracer as long as the shares are listed on a ‘mickey mouse’ stock exchange. This is about to change. Furthermore, Embracer might become a candidate for various index funds following the up-listing. Inclusion into the OMX30 would certainly mean another spurt of buyers.
Embracer invested $11bn, enterprise value today is $8bn. Is Lars Wingefors just a miserable capital allocator? The financial markets have a clear answer to this question right now. We take the other side. Time will tell.
|
This report is based on the views and opinions of Dr. Johannes Arnold, which are subject to change at any time without notice. The information contained in this report is intended for informational purposes only and is qualified in its entirety by the more detailed information contained in the offering memorandum of Nordstern Capital, LP (the “Offering Memorandum”). This report is not an offer to sell or a solicitation of an offer to purchase any investment product, which can only be made by the Offering Memorandum. An investment in the Partnership involves significant investment considerations and risks which are described in the Offering Memorandum. The material presented herein, which is provided for the exclusive use of the person who has been authorized to receive it, is for your private information and shall not be used by the recipient except in connection with its investment in the Partnership. Nordstern Capital Investors, LLC is soliciting no action based upon it. It is based upon information which we consider reliable, but neither Nordstern Capital Investors, LLC nor any of its managers or employees represents that it is accurate or complete, and it should not be relied upon as such. Performance information presented herein is historic and should not be taken as any indication of future performance. Among other things, growth of assets under management of Nordstern Capital, LP may adversely affect its investment performance. Also, future investments will be made under different economic conditions and may be made in different securities using different investment strategies. The comparison of the Partnership’s performance to a single market index is imperfect because the Partnership’s portfolio may include the use of margin trading and other leverage and is not as diversified as the Standard and Poor’s 500 Index or other indices. Due to the differences between the Partnership’s investment strategy and the methodology used to compute most indices, we caution potential investors that no indices are directly comparable to the results of the Partnership. Statements made herein that are not attributed to a third-party source reflect the views, beliefs and opinions of Nordstern Capital Investors, LLC and should not be taken as factual statements. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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