Embrace Embracer's cheap gaming play

The excitement around the industry means that most game development studios are priced for explosive, multi-year growth, and trade on forward earnings multiples in the mid to high 20s. However, Embracer Games (EMBRAC:SE), the highly acquisitive Swedish gaming business, is trading at a very undemanding price of just 10.5 times broker Berenberg’s 2023 earnings forecasts. Given the group’s track record and prospects, that valuation looks unduly pessimistic.

Today, Embracer operates a decentralised model, although it started life as a studio called THQ Nordic. Nordic is still part of the business, but now makes up around a fifth of group revenue following a string of purchases in the last few years. Embracer has acquired games studios, publishers and recently a board game company and allows them to work almost independently from each other. Share placings account for main source of deal funding, and since 2015 have enabled Embracer to buy more gaming firms than any peer bar Chinese giant Tencent, according to data from Refinitiv.

One benefit of this model is the diversification it provides, sheltering the group from the risk of unsuccessful launches. Embracer currently has 216 games in development and plans to release 25 games by March 2026. Aim-traded Frontier Developments (FDEV) which produces fewer than half this number of games on an annual basis, saw its share price tank at the end of last year when its latest Jurassic World title underperformed.

Strong profit growth

Due to this strong pipeline of games, Embracer increased its full-year EBIT guidance for 2023 and 2024 by 33 per cent and 37 per cent, respectively. Embracer has been growing quickly due to its M&A strategy. In its third quarter to December, net sales were up 135 per cent year on year – while its operating profit increased by 70 per cent.

Not all this growth was due to acquisitions. Organic revenue growth on a constant currency basis was 19 per cent, thanks in large part to the strong performance of its mobile businesses Easybrain and DECA Games, which grew 34 per cent. Together, these subsidiaries now have 292mn monthly users.

One advantage of mobile gaming is its size: over 50 per cent of the global gaming market in terms of users – with 2.6bn people playing them in 2021, according to Statista. Another is the opportunities it provides to market other games to users. As Embracer increases its mobile segment, it will then be able to cross sell these users games from its other developers.

FactSet consensus forecasts are for sales of £2.8bn (SEK 35.1bn) and operating profits of £787mn by 2023, up from £777mn and £4.9mn in 2021, respectively, and highlighting the step-change brought about by both internally-driven and acquired growth.

Increasing user acquisition costs

Bringing in new game players doesn’t come cheap, however. To push organic growth the group invests heavily in marketing, which has meant rising user acquisition costs. In the third quarter, digital marketing spend for mobile games was £72mn, or more than double the previous quarter. User acquisition costs have risen to 57 per cent of net mobile sales.

In other words, while mobile gaming has driven growth in the top line, it has come quite a high cost and there are concerns this could be margin diluting for the business. However, Berenberg expects management to increase disclosures on retention metrics and returns on acquisition costs, which should provide some reassurance. When this happens, the brokerage believes investors will “gain comfort on financial discipline”, leading the shares to “significantly re-rate”.

The marketing cost are also not capitalised. Building a strong brand, especially in the competitive gaming market, can be very valuable over time. So while costs appear to undermine profits in the short term, it is helpful to think of it as an investment that isn't captured on the balance sheet.

Expanding outside of gaming

Another point of uncertainty, which might explain the lowly valuation, is that Embracer has pivoted slightly from game publishing and development.  At the end of last year, Embracer purchased French board game company Asmodee for $3.11bn. The gaming industry has been going through a period of M&A consolidation and Berenberg has noticed that most of the deals that have not been successful are “when businesses buy out of their core areas of expertise”.

The Asmodee deal could potentially fall into this trap. However, Berenberg thinks that in this case “building a multi-channel entertainment operation makes sense both operationally and financially”. Embracer believes the board game deal will be immediately accretive to shareholders as it will add 30 per cent to operating profit, helping to offset the 7.5 per cent equity dilution involved in the cash and shares deal.

Other recent deals outside its core digital focus include publisher Dark Horse, which Embracer said would strengthen its “transmedia capabilities by adding expertise in content development, comics…and film and TV production”. Animation studio Shiver Entertainment was also added.

Netflix’s push into gaming shows companies are increasingly interested in transmedia intellectual property. Game series The Witcher, for example, was recently turned into a hit TV show by the streaming giant. In the other direction, Netflix is now optioning popular TV shows such as Stranger Things as mobile games. Embracer owns over 270 gaming IPs and the possibilities to turn these into other forms of content are considerable. And, in theory, once a game has an established and active fanbase, crossover development costs are lowered.

Undervalued portfolio

Given Embracer’s acquisition strategy, it is difficult to form a clear picture of its sustainable cash generation. As we have noted, promising organic growth figures have been accompanied by high – and rising – marketing expenses. Once Embracer starts turning its IP into multiple forms of content, we could see a step up in headline growth, and stabilising margins. The real strength, though, is in the size of its portfolio.

Popular gaming intellectual property is a red-hot commodity. According to Refinitiv, there were triple the number of gaming deals in 2021 than in 2019. And active or potential buyers are growing. Disney is competing hard for consumers’ attention – which makes gaming a popular avenue for them.

Priced at just over two times book value, Embracer’s assets look cheaply priced for the industry. This may be down to the large proportion of goodwill on the company’s balance sheet, which is quickly amortised over the course of its life. Constant share issuance is also a turn-off for some investors.

Still, peers look much more costly. Frontier Developments, which has recently stumbled, is valued at more than twice that level. Activision Blizzard, meanwhile, is valued at 3.6, despite trading 30 per cent below Microsoft’s bid price. For investors looking for cheap exposure to a growing industry, Embracer is a neat fit.

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