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Frontier Developments' investments are well placed to pay off

The video games developer has laid the foundations for significant growth over the next few years
Frontier Developments' investments are well placed to pay off

Investors should not see gaming companies as short-term beneficiaries of economic lockdowns. Good companies with the right strategies are tapping into a long-term growth market that has potential to keep on rewarding shareholders.

The success of Games Workshop (GAW) has shown the potential of gaming companies to be outstanding investments that keep on delivering. The company is somewhat unique in that it sells table-top games and does not face huge amounts of competition.

Computer gaming is a different market altogether. Competition is intense and barriers to entry in areas such as mobile gaming is low. Developing a game that can stand the test of time and deliver lots of profits and cash flow is no easy task, but Cambridge based Frontier Developments looks like it has found a winning formula here.

 

Business and Strategy

The company’s main business used to be making computer games for other companies such as Microsoft and Atari. In 2013, it decided to change and start developing and publishing its own games. This gave it much more control over its own destiny and the opportunity to make more money.

Frontier develops its own games with its own proprietary technology called Cobra which allows games code made for PCs to be moved across to other platforms such as games consoles.It has also won contracts to develop games under licence and also publishes games for third parties through its Frontier Foundry business. 97 per cent of its games are now sold through digital downloads.

The business strategy is to create games which offer engaging cinematic experiences on PCs and gaming consoles. The games are developed so that they take a long time to master and therefore create a long-term revenue revenue stream. To keep customers interested after they have bought the initial game, the games are continuously developed with a selection of free and paid pre-downloadable content (PDLC). Elite Dangerous has its own virtual currency called ARX which rewards regular engagement with the game.

Frontier has also been very good at building a player community and produces huge amounts of content for them on places such as Youtube and Twitch TV. You only have to look at the positive effect that Warhammer-Community.com has had on Games Workshop to know that this is a very good thing to do as far as brand building and repeat sales are concerned.

At the moment, the business is based around four core games.

  • Elite Dangerous (December 2014) – where players control a starship in a galaxy
  • Planet Coaster (November 2016) – building rides and sceneries in an amusement park
  • Jurassic World Evolution (June 2018) – build your own Jurassic World. This is a third party licensed game from Universal Games and Digital Platforms.
  • Planet Zoo (November 2019) – players create habitats for their chosen animals and then control and manage their lifestyles in it.

The longevity of the core Games is there for all to see in the company’s financial results to May 2020. Of the £76m revenues generated by the company in the year to May 2020 60 per cent have come from the first 3 titles. Elite Dangerous had its highest ever player numbers in 2020 – 7 years after it was launched in beta. The hope is that Frontier can replicate this with its other games.

Of the 10 million units sold last year, Elite Dangerous accounted for 3.5 million, Planet Coaster 2.5 million, Jurassic World Evolution 3 million and the recently released Planet Zoo 1 million. The latter has been Frontier’s fastest selling game to date.

The company has been very successful in taking ideas from games it used to make for others and turning them into successful games for itself. Planet Coaster has been developed to take on Atari’s Roller Coaster Tycoon 3 Game (which Frontier develops for it) and has successfully done so. Planet Zoo aims to be a much better game than Microsoft Zoo Tycoon.

 

Heavy investment is depressing short-term returns and free cash flows

The business is performing well, but its performance is volatile and is heavily influenced by the scale, frequency and timing of new games releases. 2019 was a great year as Jurassic World Evolution was released at the start of the financial year and coincided with a new film release. 2020’s new release of Planet Zoo came half way through the year and did not have the same full year impact and was the reason why revenues were lower.

 

Frontier Developments: Key financials

£m

2016

2017

2018

2019

2020

Revenues

21.4

37.4

34.2

89.7

76.1

Op Profit

1.2

7.8

2.8

19.4

16.6

Net profit

1.4

7.7

3.6

18

15.9

Free cash flow

-1.8

3.9

-7.9

15.8

9.5

Invested capital

24.2

32.2

55.9

75.6

132.8

      

Op margin

5.6%

20.9%

8.2%

21.6%

21.8%

FCF margin

-8.4%

10.4%

-23.1%

17.6%

12.5%

Cash conv.

-128.6%

50.6%

-219.4%

87.8%

59.7%

ROCE

5.0%

24.2%

5.0%

25.7%

12.5%

Source: Annual reports/Investors Chronicle

 

Profit margins remained healthy mainly because Planet Zoo is Frontier’s own games and has no third-party royalties. 2019 shows that Frontier can be a very profitable business indeed but cash flows and ROCE are being depressed by heavy investment in the business. Excluding leases, The company has added £85m of new investment since 2016. Most of this has been in new staff to develop new games which has seen a big increase in capitalised development costs – more on this later.

 

Growth prospects look very good

Frontier now needs to leverage this investment to grow its revenues, profits and cash flows and boost its return on capital employed (ROCE). It looks to be in a very good place to do so. New games need more software developers but existing games need the attention of fewer staff and so with a strong pipeline of new game releases, I think there’s a good chance that returns could improve significantly going forward.

This year will see the benefit of a whole year’s contribution from Planet Zoo and the release of Odyssey for Elite Dangerous in early 2021. Planet Coaster will launch on PlayStation and XBox, while Jurassic World Evolution will launch on Nintendo Switch. The Frontier Foundry will begin to make a contribution with two new games.

Looking further out, the company has a four year licence to develop and publish a game for Formula 1 which has proven to be very popular and in 2023 will launch an Warhammer Age of Sigmar game in partnership with Games Workshop.

The company is optimistic that its investment in people can produce two internally developed games a year from 2023 and 6 Frontier Foundry games a year. If it can keep the existing portfolio of games growing or stable then the leverage effect on revenues and profits could be very big.

The company thinks that revenues will rebound strongly in 2021 to £90-£95m with City analysts predicting rapid growth to £164m by 2023. Operating profit and earnings per share(EPS) are expected to grow rapidly from £19.8m/46.9p to £37m/85.3p and free cash flow from £11.8m to £30.4m according to SharePad.

If this comes to pass then the current share price of 2,372p (50.6x 2021 PE) while expensive may actually be worth paying up for.

One thing to keep an eye on is that big development spending on games qualifies for 80 per cent video games tax relief which means Frontier has a very low tax charge. This will increase as development spending falls off and taxes will rise. That said, this is not likely any time soon and when it does free cash flow should increase.

 

Analysis point: Capitalised development costs

Providing it meets certain criteria, money spent on product development can be capitalised (put on the balance sheet) and amortised (expensed in the income statement) over a number of years against the revenues it produces. Frontier Developments currently capitalises around 80 per cent of its annual  development spending.

This can lead to accusations of aggressive accounting and that a company is trying to boost its profits by putting costs like wages on its balance sheet rather than expensing them through the income statement. You should compare the cash spent on development with the costs expensed through the income statement and the amortisation. When you look at it this way, Frontier Developments profits definitely get a boost relative to its cash flow – £8.6m in 2020.

 

Frontier Developments vs Games Workshop capitalised development costs

FDEV

       

Year

Cash spent

Capitalised

Expensed

Amortisation

Total inc statement

Profits vs cash

Cap %

2016

9.5

8.9

0.6

2.6

3.2

6.3

93.7%

2017

12.7

9.6

3.1

4.5

7.6

5.1

75.6%

2018

15.9

13.4

2.5

6.1

8.6

7.3

84.3%

2019

20.5

13.4

7.1

7.8

14.9

5.6

65.4%

2020

24.6

19.8

4.8

11.2

16

8.6

80.5%

        

GAW

       

Year

Cash spent

Capitalised

Expensed

Amortisation

Total inc statement

Profits vs cash

Cap %

2016

8.5

4.6

3.9

3.8

7.7

0.8

54.1%

2017

10

5.7

4.3

2.9

7.2

2.8

57.0%

2018

11

5.4

5.6

4.1

9.7

1.3

49.1%

2019

13.4

7

6.4

5.3

11.7

1.7

52.2%

2020

15.9

6

9.9

4.9

14.8

1.1

37.7%

Source: Annual reports/Investors Chronicle

 

Games Workshop capitalises much less of its development costs and its cash costs and income statement costs are fairly similar. Its amortisation rate is based on 50-80 percent reducing balance each year.

Does this mean that Frontier Developments is guilty of aggressive accounting?

Not necessarily. It only capitalises development on new games and not existing ones.The cost of free updates to existing games is fully expensed.  Its existing development pipeline is being amortised over 3-5 years with Planet Zoo over 4 years. The success and longevity of games such as Elite Dangerous suggests that its policy is not unreasonable at all. I’d prefer to see these costs fully expensed but I don’t think there’s anything bad happening here.

It also must be noted that Frontier is still a relatively young company as far as developing its own games is concerned. This is why its spending relative to the size of its business is much higher than a business such as Games Workshop (which is a different type of gaming business as well).

The other thing to look at is the amortisation rate – the amortisation expense as a percentage of average capitalised development costs. Frontier Developments has had a higher rate than Games Workshop in recent years. These are different businesses to some extent but have similar characteristics but I profess to not knowing what the right rates for each business should be.

Codemasters, a developer of racing games had an amortisation rate of 27.1 per cent last year. This higher rate is probably down to the shorter life of racing game editions where things like drivers and cars change rapidly and need to be updated with new releases more frequently.