Ubisoft – Enough Upside For Good Returns (UBSFY)

Ubisoft logo in front of their local headquarters. Ubisoft entertainment is a video game development company from France spread worldwide

BalkansCat/iStock Editorial via Getty Images

Author’s Note: This is the reduced version of an article published on iREIT on Alpha back in early March 2022.

Now, I don’t like investing in gaming companies all that much. I’ve written about this a few times in the past, both as a general sort of article stance, but also more focused on individual businesses like Activision Blizzard (ATVI). Their cyclical characteristic and near-opaque long-term visibility make it hard for me to consider them appealing investments at all but trough valuations.

The essential target for my investment in a company like this is simple. I’m buying it at pennies on the dollar (or similar) and waiting for it to either revert to historical higher valuations, or for someone with deep enough pockets to acquire them.

This is not an investment method I often indulge in – but recent pricing action on Ubisoft Entertainment (OTCPK:UBSFY) proves the thesis that nothing is uninvestable at the right price – in theory.

Let’s give this business a look.

Ubisoft – What does this company do?

Now, for those of you unversed in games generally – Ubisoft is a gaming company, or entertainment software company. That means that they research, plan, develop, produce, sell and update gaming software products sold across multiple platforms, such as PC, Xbox, and PlayStation.

It’s one of the oldest companies still on the market in its relatively current form. It was founded back in 1986 and operates in 29 countries. A majority – and a vast majority at that – of 35%+ of the company’s entertainment products are being sold on PlayStation 4, with 20% and 27% on Xbox and PC respectively. The remaining is Nintendo Switch as well as Mobile, or older consoles.

The sales model has shifted massively over the past few decades. Where previously companies like Ubisoft would sell their products through distributors/stores, the company now operates its own digital and retail channels. Digital has grown to encompass over 65% of all of the company’s sales and delivery options, and subsequent entertainment content sales ‘DLC’ (think of that as an addition to the original product) is made digitally as well.

As with many other gaming companies, Ubisoft has been targeting to grow its mobile gaming division. Mobile gaming has a very high rate of margin overall and has been massively profitable for many businesses, requiring only a small part of the development team of a title/product for a larger platform, such as the PC or Xbox.

Gaming titles sold either through:

  • Straight retail, at a fixed price (usually $40-$80/title), and usually with the option of buying in-game “items” or additions through real money. Another revenue driver after the sale is the sale of additional content, known as ‘DLC’.
  • So-called Free-2-Play (F2P) games which are free to start playing, but require the player to purchase in-game items or methods to advance in a “normal” manner. Think of this like watching a football game, but every 10 minutes someone asks you if you’d like to stop to watch the game at half-speed for only $5. (A rough comparison, but it’ll do)

What sets Ubisoft apart from its peers is that it’s been a largely organic grower for its 30+ years of active life. The usual trend in this business is inorganic growth in addition to organic growth, especially as companies generate cash.

One of the primary legacy challenges of video game developers was its income cycle. Back in the ’90s and early 2000’s a company could spend 1-5 years on a title while making essentially nothing, only to once it was put to sale have a massive windfall of cash for 1-2 years – or not, as it failed. The failure of this business model is clear – it’s unpredictable. Because of this, gaming companies were quick to hop on the SaaS trend, where gamers are more encouraged to pay as they play, pay for subscription, or have some sort of recurring sales revenue.

Ubisoft is no different, and together with Electronic Arts (EA) offers access to an online service that gives games access for a subscription fee.

There is strong competition in this industry, but Ubisoft’s portfolio includes major AAA titles such as:

  • Watch Dogs
  • Assassin’s Creed series, including around 12 years of games.
  • Just Dance
  • Far Cry
  • Tom Clancy’s Rainbow Six/Games series

The Assassin’s Creed series, where you play an assassin/adventurer through various historical periods on earth, has 95 million unique players and is the best-selling game series for Ubisoft, with Tom Clancy’s Rainbow Six Siege at 55 million unique players. (Source: VGsales)

So, because of that, Ubisoft has a lot of strength and backbone to its company. Many analysts, including some I follow, would argue with me that there is nothing justified to reflect this drop in the company’s share price.

Ubisoft Share price/target

Ubisoft Share price/target (Alpha value)

I will very clearly state to you that the analysts with this stance lack fundamental insight into, or underestimate the impact of a company making lackluster products.

Analysts will argue that these assets are “hard to operate”. I will instead clearly state that Ubisoft, for the past few years, has repeatedly failed to innovate. People buying games are not stupid – nor are they easy to please. Historically, Ubisoft was able to produce hit titles that could carry the company for years on end. The past few years of releases have seen repolishings and insufficient innovation and improvement to titles such as Assassin’s Creed: Valhalla compared to earlier titles.

Also, and this is another big deal, competition has increased. We have peers coming out with titles like Ghost of Tsushima which when compared to Valhalla, is a superior title in almost every way.

Now, a quick background for me here – because this is relevant.

I’m 36 years old. I’ve been playing computer/console games for 30 years. I was among the best players in Sweden in StarCraft when I was a teenager, and I was the world’s first player to max all areas in the MMORPG Vanguard: Saga Of heroes. I’ve spent the better part of 10 years playing games quite seriously, on a semi-professional level. This is relevant because I can actually tell when a game is “good” or not, in the sense that it will last beyond the initial sales surge. When I read the financial analysis of a company like this, I can easily spot when an analyst just doesn’t “get” the fact that a gaming company just isn’t innovating or producing titles that people want to play or enjoy for a long time.

Compare The Witcher 3, a good game, to one of Ubisoft’s latest titles. It’s not comparable, despite to a layman probably looking very comparable. The Witcher 3 was released almost 8 years ago, and it’s still generating massive sales revenue. Ubisoft’s 8-year old titles are barely moving.

This influences profitability and the likelihood of future profits. And this is part of the reason for the share price decline we’re seeing.

A “failure to innovate” is extremely hard to address, because it’s entrenched in evolving company culture. There are many examples of this. Blizzard is one of them. Since releasing Overwatch, many players feel their games no longer hold up to what was once released back in 2010 and before. Ubisoft is certainly on this trajectory, only Ubisoft actually has it worse than many others.

Ubisoft operates one of the costliest development studios in the world. This is a good thing in one way because it implies that the company spends a lot of money on its development – which is what you need to do. However, when you look at the results of that development, it’s clear that the leadership producing the titles in some way is sub-par, compared to what else is out there.

In addition, the market conditions are tightening. The Chinese market, a major part of Ubisoft, is restricting various avenues, which could hinder the company’s overall expansion.

Its current sales split sees Ubisoft selling around 38% of its annual sales to Europe, with 46% in NA. The remaining 13% are in the rest of the world. The biggest important singular markets in Europe are the UK at 7.1%, France at 7%, and Germany at 6.9%.

Its sector and structure make it incredibly dependent on the success of its blockbuster releases, such as Far Cry and Assassin’s Creed. A massive marketing engine usually ensures that reviewer scores are on the higher end for its titles. It’s also unfair to call many of their titles “bad” – because they really are not bad. It’s just that they lack the spark and innovation other products bring to the table.

I’m going to show you an example.

Metacritic Valhalla

Metacritic Valhalla (Metacritic.com)

Metacritic allows for an effective aggregation of verified reviewer scores, but it also allows for verified user scores. When the correlation between these is off, you can usually understand that there is some sort of incentive behind the scenes that are affecting these scoring trends. In this case, the correlation is quite high, but Valhalla is still “only” a 7.3 on a user basis.

Compare that to this.

Ghost of Tsushima Metacritic

Ghost of Tsushima Metacritic (Metacritic)

See the difference? People who don’t play games couldn’t explain to you what makes one better than the other. They both look amazing, sound amazing, and seem amazing.

But Ghost of Tsushima is sharper in terms of combat. It has better writing. It has a more fleshed-out world. All those things, big and small, that make users love it more.

And this has been the trend with Ubisoft games for some time. When you depend on your blockbuster releases to this degree, their relative failure compared to your peers does much to harm you.

Ubisoft has safe overall debt and a 1X EBIT debt position. It’s moving towards having a net cash position, which is similar to its peers. It has no yield. It has annual revenues of around €2.2B on an annual basis. An investment in Ubisoft has been a bad investment on a 1-year basis, a positive investment on a 5-year basis, and a good investment on a very long-term basis. Long-term Ubisoft shareholders have done extremely well.

However, the future is less certain.

More on the issues with Ubisoft

As I eluded to in the earlier portion, the issues with Ubisoft are complex. They are so complex, in fact, that I’m wondering if some of my analyst peers covering the company really understand them.

My peers point to the fact that their studios have “amazing creative talent” that has “proven time and time again to create long-lasting franchises”. I view that mostly as fluff, because the talent, as this industry has proven time and time again, is very fleeting. Employees will be quick to move to a better-paying or more flexible position if it is offered. The company’s excessive reliance on key people in their teams is a potential detriment to them because if one person leaves, an entire project could be de-railed for months.

Ubisoft is targeting a strategy where the company wants to release fewer titles. They want to increase the amount of money that players spend on one title. Recurring investments.

This is a good thing.

However, it’s only a good thing if they at the same time increase the quality of the titles they bring. If they push their current titles and expect their stickiness to increase without increasing quality or innovation, I believe them to be in for a rough awakening. We could instead see a profit reversal because sales revenue from other titles is suddenly declining.

The addition of mobile gaming should work as a cushion to really generate some high-margin profits for Ubisoft, provided that nothing massive happens to disrupt overall mobile gaming appeal. Some of my analyst peers also point to Ubisoft entering the e-sports arena, which I believe to be an absolute non-starter given their lack of any serious e-sport title. And no, Rainbow Six Siege, with a player drop in the double digits and a concurrent active player/account relationship of less than 0.15% does not count. Not when you have actual e-sport games with active monthly player/user account relationships of over 35-60% (League of Legends) with active concurrent players more than 10X the number of Rainbow Six.

The way that some of my colleagues point to “e-sports” as a general thing is similar to the way total addressable market (TAM) is being used by some growth companies. It’s not enough to say a market exists or has a certain size.

You need to actually be able to address the market.

Ubisoft has failed to do this with any amount of reliability.

Ubisoft also has a massive R&D/sales ratio compared to its peers. It’s ~35%, meaning it’s at the top of the pyramid. Again, this is theoretically a good thing, but the quality of the products that are being released leads me to believe this R&D spend is not being utilized in an effective manner.

The combination of:

  • High expenses
  • Increased regulations & risk (including China)
  • The company’s new strategy combined with its recent 10-year track record

This leads me to view the company’s upside with a certain amount of dubiousness. I see risk. I see a lot of it.

Case in point.

One savvy analyst (Matthew Walker) during the last earnings call time period asked why, in an environment, when multi-billion dollar deals are being struck for developers like ATVI, isn’t UBI exploring the possibility of an accrediting M&A or takeover. His specific question was:

The first question is in a consolidating industry. I guess, I’m just wondering why you guys haven’t had an offer given the embedded value in your IP. Is that because in order to be acquired, you have to signal that you want to be acquired but you haven’t done that?

(Source: Ubisoft 3Q22 Earnings Call)

And the response was this.

Frédérick Duguet

Thank you, Matthew. So on your first question, we will not speculate why people not have made any offer. What is the interest…

Yves Guillemot

And if any of afterwards were made.

Frédérick Duguet

Absolutely. So I can’t comment on that any further.

(Source: Ubisoft 3Q22 Earnings Call)

I can tell you why they haven’t received any sort of offers. Because the people with actual industry knowledge know that Ubisoft, at this level, isn’t necessarily cheap yet.

This illustrates pretty well some of the issues with this gaming company.

The upside of Ubisoft

I’m being excessively and exceedingly harsh with this company. There are reasons for it. Many followers and analysts have excessive price targets and very rosy pictures of what Ubisoft “should” be doing. I believe these perspectives are based on an absolute lack of knowledge, including by some very solid analysts who really should know better.

However, that being said, Ubisoft does have a significant upside – or I wouldn’t be writing this article.

The titanium-like fundamental strength of its legacy and new IPs means that Ubisoft is sitting on a pile of gold if the company is able to inject life into its currently lackluster franchises and games. Because if they do this, their IP will work as a funnel to immediately boost any game they make up to the top of the sales chart, with people happy to buy – and spend! – money on the game, both initially and after.

Because the thing about people playing games is, we’re happy to spend money on a good game. We don’t “not mind” it – we’re happy to.

But – if you offer gamers the amazing option of buying a “blue” cloak instead of your brown one for $5 in a game that nobody will play in 3 months….weeeeeeeell, we’re probably going to say “no”.

I believe the reason other companies are waiting for eventual offers is to see what Ubisoft may be trying to do moving forward.

Also, I may be wrong. There might at be a company out there that’s preparing an offer for Ubisoft right this minute – I’ll show you why in a bit.

There is also the historical precedent of Ubisoft turning its development and games around. It wouldn’t honestly take that much. Get some better writers, some more resources to system integration, and a bit of innovation – and you have superb, solid games. They would not have to do much – and Ubisoft has intelligent employees – they know this.

This is a company in a bit of a slump – but it’s not as big or unrecoverable as i might have implied above. Its catalog/portfolio of games is well-known across the entire world. They have the infrastructure and the partnerships in place to profitably deliver products both physically and digitally, and they’re working the mobile angle to increase this.

Ubisoft also has a partnership with Tencent (OTCPK:TCEHY), enabling it to effectively promote and publish in the massive Chinese market.

All of these are upsides – and a gamer like me is liable to suffer from a bit of inherent bias that might, or might not, lead to mis-assuming some upside or up-playing some downside.

While on the cash side, I’ve already downplayed my assumptions for 2022-2023 numbers due to delays in the company’s F2P-titles, I’m also saying that there is significant upside here.

The valuation for Ubisoft

Valuation for a gaming company is very complex because modeling it requires assumptions about high sales growth rates. DCF would have to assume sales growth rates of going on 8-10%, based on the company’s entry into mobile gaming and higher-growth industries. These entries may indeed give Ubisoft the sort of short-term growth the company may be looking for, but it wouldn’t change the overall growth profile. Overall, I’m assuming a 5-10% growth rate for the DCF, which is the highest range I’ve ever considered for a company – but justified given the fundamentals.

The company has low debt, and a relatively low cost of debt, ending at a WACC of 7.6%. Assuming a range of 5-10% annual EBITDA growth, the implied future equity value on a per-share basis is between €45-€55. But I intend to weight DCF at a relatively low percentage/relationship due to its massive reliance on growth rates – which in my opinion, aren’t that easy to forecast here.

It’s key to point out though that in the case of actual 10-11% EBITDA growth in a bullish case, the implied fair value on a DCF basis easily goes up to over €55/share.

Instead, public comps and NAV offer a better view here. Yield isn’t important because Ubisoft has no yield – and no plans as of yet stated to include one. Public comps are pretty easy. You have CD Projekt (OTCPK:OTGLY), Take-Two (TTWO), Electronic arts, And Activision Blizzard. ATVI is the largest, and already M&A’ed. The average valuation for its peers is around 21-23X P/E, with Take-Two at the highest at 30.5X and EA at 19.1X. At its current valuation of P/E of 22-28X depending on what actuals or estimates you use, the company doesn’t show any particular undervaluation here.

To be fair, I am allowing for a 15% premium in the P/E here, owing to Ubisoft’s history and portfolio as well as its maturity – which even given everything, has substantial value. At a 2.6X P/book, the company is also firmly undervalued to an average of about 3.8X. When it comes to EV/EBITDA, I’m assigning a 30-35% discount due to IFRS reporting, which considers amortization differently and because of it reports substantially higher EBITDA than its US peers.

NAV is easier. We use a sector average of 4-5X Sales multiple to give us a gross asset valuation of €11B on the mid-point given that multiple for the company’s various geographical sectors.

Debt is low – and net this is a €10.85B which comes to an implied NAV/share of €80/share.

This is where we see the real potential for Ubisoft. However, this upside is entirely dependent on the company being able to monetize its portfolio on the basis of a 4-5X sales multiple, which in turn is based on the company’s ability to turn around and once again innovate in its licenses.

Overall, it’s easy to see that in DCF, NAV, discounted EV/EBITDA, P/Book, the company trades at a discount to any real fair value here. Only straight-line P/E and Dividend yield gives a different picture.

My combined price target comes to €52/share. And this is a price target I mean. I say that because, despite a €66/share price target from Equity investors and an average of €61 from S&P Global, the number of analysts that aren’t at a massive “BUY” recommendation are over half. In addition, S&P Global has an incredible target range, from €38/share on the low end, that essentially lowballs the entire company’s portfolio. The high-end target meanwhile is almost €120. I have no idea what this analyst believes or what he bases it on. I’d have to model for a 30-40% EBITDA growth rate for this to be even remotely possible – but then again, there are those that consider Tesla (TSLA) worth $5,000/share.

When I say €52/share, I mean that the company’s assets are attractive to me at that price. That’s also why I’ve started a small position. I always put my money where my mouth (or my text) is.

Thesis & Putting it all together

The gaming space is an inherently risky area to be in. Never forget this. The more I read analysis by my colleagues, the more I realize that this is very hard to forecast unless you know your stuff in the space – because many failures these analysts have had, are things I foresaw over 7 months before.

At this point, I do believe Ubisoft is worth your attention. I believe the possibility of an accrediting, outside M&A, cannot be discounted, and such a price would likely come at a NAV premium, perhaps as high as 4-6X Sales or so. At that point, you stand to essentially double your money.

For the long term, I believe a €52/share price target will allow you to remain profitable in this company, and that’s where I set my target. I bought my stake at €45/share.

The relevant ADR for Ubisoft is (OTCPK:UBSFY). It’s relatively liquid, and it’s a 0.2X ADR, meaning every share is worth 1/5th of the native. The implication for the ADR is that Ubisoft trades at a 19.1X P/E – again, it really depends on what numbers you consider here. The company’s history is extremely choppy.

Ubisoft Valuation

Ubisoft Valuation (F.A.S.T graphs)

Doing any sort of forecast based on this is hard. Analysts can’t be trusted – even with a 10-20% margin of error, their forecast accuracy is lower than 20%. You’d be mathematically safer betting on a coin toss.

This illustrates perfectly why I don’t like any valuation method that assumes, or models for a specific, linear, or even proportional increase in sales growth. The history really shows us here that the only time to buy Ubisoft is when the stock is cheap.

It is cheap now.

My two reasons for investing in Ubisoft here are:

  • I believe that it can be conservatively said that the company’s assets/IP are worth more in a per-share NAV than the current implied valuation. I believe that to be conservative, at least 15-18%.
  • In the case of an accrediting M&A, which is possible if the company goes lower or something might already be in the woodwork, I believe Ubisoft would be priced similar to its peers, and warrant a 4-5X sales multiple. This would imply a near-100% upside.

I believe these two reasons to be good enough for a “BUY”, even with all of the risks mentioned.

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