CFA Institute Research Challenge hosted by CFA Society of Poland Kozminski University 1 Kozminski University – Student Research This report is published for educational purposes only by students competing in the CFA Institute Research Challenge CD Projekt SA (CDR) Date: 2015/02/10 Current price (15/02/10): PLN 16.20 Recommendation: BUY (29.5% upside) Ticker: CDR:PW (Bloomberg) USD/PLN (15/02/10): 3.71 Target price: PLN 20.99 (USD5.65) Table 1: Composition of Target Price CDR – a risky pick and an upcoming success story… Valuation method Weights PPS Target (DCF) 0.75x 19.63 CD PROJEKT S.A. (CDR) is a highly risky security that already promises high returns in Target (Multiples) 0.25x 25.04 the short to medium term. We therefore issue a strong BUY recommendation with a Target price 20.99 target price of PLN 20.99 (USD5.65), an upside of 29.5% to the current share price of PLN 16.20 (USD4.36, as of closed markets on 2015/02/10). Due to a very promising Market price 15/02/10 16.20 upcoming project cycle with two major AAA titles in the 2015/16 pipeline, The Witcher III Upside 29.54% and Cyberpunk 2077, CDR will profit from an essential sales boost at stable to increasing margins, resulting in strong cash flows without incurring debt. Interesting will be future Source: Team estimates management decisions, including potential dividend payments, expansion projects and Table 2: Market Profile of CDR acquisitions to strengthen CDR’s international footprint. Market profile 52-week price range (PLN) 12.96-18.38 Strong outlook together with numerous upside potentials… 2014 dividend yield 0.00% Other than during CDR’s last release cycle, the Witcher brand is globally established Shares outstanding (in '000) 94,950 based on a strong customer base with buying power while the Cyberpunk brand is Market capitalization (PLN mm) 1,534.39 established in the U.S. since the late 1980’s. Also a debut for CDR is the release across Shares held by mgmt 35.8% all major platforms (PC, PS4, XBOX One), thus paving the entrance into the much more Free float 44.2% lucrative console market. The footprint was further strengthened by the sale of the ROE 2015E 49.2% majority in CDR’s subsidiary CDP.pl in Q4-14, divesting the pure distribution business ROE 2016E 36.0% with low entry barriers and a rather grim outlook due to increasing digital sales. Main P/BV (2015/02/10) 9.4x upside potential is incorporated in future sales of two to three AAA titles in 2018/19, P/E 2015E 10.6x higher margins in the long term due to digital distribution, a successful GOG Galaxy, tax P/E 2016E 9.2x savings from intercompany transactions, materializing revenues from selling rights to the EV/EBIT 2015E 9.7x Witcher engine as well as financial upsides such as optimization of the capital structure. EV/EBIT 2016E 9.1x Source: Team estimates, Bloomberg Cash-intense balance sheet without leverage… Graph 1: KPIs over Time The waiting period of more than three years will finally be over in Q2-15, with CDR’s prime title The Witcher III producing a substantial cash flow that will further strengthen 480,000 CDR’s already extraordinarily cash-intense and debt-free balance sheet. No signs point 380,000 towards utilization of the numerous approved credit lines. On the contrary, CDR will be 280,000 flexible enough to finance (organic/M&A) growth internally with remaining means for 180,000 potential (first time) dividend payments. On the medium term, we see massive 80,000 optimization potential in CDR’s capital structure on the way to a four- to five-games (20,000) pipeline. 2012A 2013A 2014E 2015E 2016E 2017E 2018E 2019E 2020E Potential hurdles to overcome… Sales EBIT Net profit The highly volatile business model of game development bears huge risk in itself, Source: Team estimates especially in the Mid Cap stage with a limited pipeline of releases. The more important is Graph 2: Monte Carlo Simulation the quality of the upcoming titles, currently leading the rankings of most-anticipated titles in 2015. If the two upcoming blockbusters should be unsuccessful, CDR would tumble from a rising star to mediocrity with high volatility and no dividends – a highly unfavorable scenario in which the stock would most probably react in the higher double-digit range. However, game footage, beta tests and fan reviews point the other direction – rather an imitation of success stories such as Elder Scrolls 4/5 (Bethesda Softworks LLC) or Diablo III (Activision Blizzard, ATVI:NASDAQ GS). We therefore do not only forecast risk to be adequate in contrast to expected return but rather that upside risk beats downside risk by far – also due to the promising management team. Source: Team estimates Graph 3: CAGR over 3y Cycles Actuals Estimates 48.8%% 43.1%% 45.6%% Key ratios (CDR) 2012A 2013A 2014A 2015E 2016E 2017E 2018E 2019E 2020E 33.1%% 31.3%% Cash ratio 61.4% 88.2% 47.8% 151.7% 279.5% 275.8% 322.3% 445.6% 373.9% 29.8%% Operating margin 17.3% 10.5% (3.2%) 48.5% 49.3% 36.0% 49.3% 46.3% 30.2% Net profit margin 17.1% 10.4% (1.9%) 41.9% 46.2% 40.9% 45.0% 43.0% 31.3% 12.2%% 11.1%% Return on equity 18.6% 8.9% (1.7%) 49.2% 36.0% 12.8% 26.7% 20.5% 8.2% Total asset turnover 80.9% 65.3% 54.4% 73.2% 56.0% 22.9% 44.0% 37.6% 20.1% Inventory turnover 491.6% 273.6% 154.3% 367.4% 449.4% 134.0% 351.6% 434.7% 166.5% '12-16% '12-20% Long-term debt to assets 0.5% 0.7% 0.5% 1.5% 1.0% 0.7% 0.6% 0.5% 0.4% Sales%CAGR% EBITDA%CAGR% EBT%CAGR% Net%Income%CAGR% Earnings per share (in PLN) 0.30 0.16 (0.03) 1.54 1.78 0.73 2.08 2.02 0.84 Dividend payout ratio 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Source: Team estimates 1 CFA Research Challenge CD Projekt SA (CDR) 2015-02-10 Graph 4: CDR Group Overview Business Description CD Projekt SA Group CD PROJEKT S.A. is a Polish developer and distributor of digital entertainment, mainly video games. Headquartered in Warsaw and founded in 1994, CD PROJEKT Capital Group consists of two main companies: CD PROJEKT RED and GOG.com. In 2013 the 1 group had revenues of c. PLN 140m and a net income of approx. PLN 28m. Source: Company information CD PROJEKT RED operates since 2002 as the game development division for AAA role- Graph 5: Direct Physical playing games (RPG), mainly video games. Offices are located in Warsaw and Krakow Distribution of TWIII with around 270 employees. The biggest projects of CD PROJEKT RED were The Witcher I (Polish: Wiedzmin) and The Witcher II: Assassins of Kings both basing on the series of fantasy short stories by the Polish writer Andrzej Sapkowski. Two upcoming projects are The Witcher III: Wild Hunt, which is planned to be released on May 19th, 2015, and Cyberpunk 2077 with the official launch date to be announced. The release date of The Witcher III was delayed twice by CDR in order to assure the high quality of the game.2 The Witcher I (TWI) and The Witcher II (TWII) together sold more than 8 million copies globally, even though TWI has been only available on PC and TWII additionally on the CDR Headquarter platforms Xbox 360 and Linux. The Witcher III (TWIII) will furthermore be available on the Source: Company information new Xbox One and PlayStation 4. From the side of the company, no official forecasts regarding the sales number of TWIII or Cyberpunk 2077 exist. Previous to its release, the Graph 6: Shareholder Structure game received more than 170 awards and is heavily anticipated throughout the world (see Graph 8). Graph 5 shows territories, in which physical distribution of TWIII will take place directly by CDR. In addition to these bigger projects, two mid-range games with around 20 hours of gameplay will be released.3 GOG.com (formerly Good Old Games) acts since 2008 as the digital distribution platform of the group and since then became the world’s third biggest player in this market behind market leader Steam. With around 80 employees, it provides games and movies for PC, Mac and Linux worldwide.4 A new project of GOG.com is GOG.com GALAXY which acts as a cross-platform multiplayer meaning two or more people are able to play games together online.5 Its beta version is active since October 2014. A vision of the company is not to use digital rights management (DRM), which is a widely spread anti-piracy tool in the Source: Company information video gaming industry. As the company does not believe in the protection through DRM, GOG.com is the only platform so far providing DRM-free video games online resulting in a Graph 7: CDR Stock Movements unique selling proposition for GOG.com.6 compared to WIG20 and S&P500 Until 26 November 2014, a third company was part of the group named CDP.pl. It was the oldest one operating since 1994 and accounting for the physical and digital distribution of video games, motion pictures and eBooks throughout Poland.7 In 2014, CD PROJEKT sold share blocks multiple times resulting in an ownership of remaining 8.29% of total CDP.pl shares.8 The shareholder structure has been nearly consistent since the IPO at Warsaw Stock Exchange.