Update Equity Research 15 December 2020 Embracer Group Sector: Gaming Loading the Next Level FAIR VALUE RANGE BEAR BASE BULL Incentives to Acquire, but also Deliver 130 250 300 Our view is that Embracer has given the key personnel incentives to obtain growth and certain financial targets through acquisitions. But we do not believe they have incentives to EMBRAC.ST VERSUS OMXS30 acquire for the sake of its own, but to achieve overall profitability and growth in the Group. OMXS 30 In contrast to many other companies, Embracers shareholders will not be further diluted if Embracer Group 250 those entrepreneurs get their full earnouts. However, if they do not deliver according to the terms, shareholders instead will benefit from a stronger balance sheet as compensation. 200 150 The Sweet Spot 100 We believe Embracer still has much room to grow through small to medium-sized 50 acquisitions. And, of course, all former acquisitions will boost growth for many years to 0 come. The risk is also lower in releasing AA titles as the investment is lower, with a 16-dec 15-mar 13-jun 11-sep 10-dec potential of a higher return on investment. We take a deeper dive into, three of the more REDEYE RATING interesting acquisitions since our last research update, namely Flying Wild Hogs, Purple Lamp Studios, and Vertigo Games. 5 Only a Bump in the Road 4 4 The Embracer-stock has shown some weakness lately but has still advanced 140% this year. We assume the weakness is only temporary due to investors feeling skeptical about People Business Financials the acquisition pace (too many, too small, and too fast). Another explanation is that the Q3- result (October-December) is also expected to be the weakest quarter this fiscal year. However, we believe this “big embracing elephant” will continue to grow significantly in a more long-term perspective. We have increased our estimates until 2023 and our valuation. KEY STATS Our new fair value range is SEK 130-300 (SEK 95-260) with a base case of SEK 250 (SEK Ticker EMBRAC.ST 205) per share. Market First North Share Price (SEK) 174.0 Market Cap (MSEK) 67447 Net Cash 20E (MSEK) 5649 KEY FINANCIALS (SEKm) FY20 FY21E FY22E FY23E Net sales 5250 8910 11356 13468 ANALYSTS EBITDA 1822 3830 5436 6886 Tomas Otterbeck Op EBIT 345 2582 3983 5205 [email protected] EPS (adj.) 2018 2019 2020E 2021E 2022E 2023E EV/Sales 4.8 8.2 6.2 4.6 Danesh Zare EV/EBIT 72.6 28 18 14 [email protected] Important information: All information regarding limitation of liability and potential conflicts of interest can be found at the end of the report Redeye, Mäster Samuelsgatan 42, 10tr, Box 7141, 103 87 Stockholm. Tel. +46 8-545 013 30, E-post: [email protected] REDEYE Equity Research Embracer Group 15 December 2020 Top of Mind: M&A, Too Many and Too Fast Shortly after the very strong Q2-results, the focus seems to have shifted to the high acquisition intensity in the last two quarters in Embracer. We think that it is a good thing that the potential risks have been a topic lately, as a subject to test our conviction in the investment case. It is not a secret that Embracer, Stillfront, and now EG7 in the gaming sector have spoiled shareholders with high flying stock prices and, more importantly, mostly great financial results. However, a few years is a short period to determine the impact of all those acquisitions. And more “moving parts” in the Groups, of course, makes it harder to predict the future. More moving parts also create a more critical demand for an effective organization, which we believe Embracer has with its six business areas. For example, we believe that the size of the acquisitions is in many ways more important than the number of acquisitions. The game studio “Flying Wild Hog” was approximately 60% of the initial purchase price during the quarter. Wild Flying Hogs and the VR-focused studio “Vertigo” have been the two largest acquisitions in the last six months. Both have been acquired by the subsidiary Deep Silver, not the recently more M&A intensive Saber Interactive and DECA. Incentives to Uphold the Acquisition Pace The two added business areas this year are Saber Interactive and DECA. The three founders of those two companies have earnouts with certain financial milestones in 3-7 years. If they are not able to reach certain milestones their Embracer-shares they “borrowed” in the acquisitions can be reduced. This is a way for Embracer to secure that key personnel stays loyal. The subsidiaries’ incentives are aligned with the Group, and the management in the Group of course has the power to neglect acquisitions that are not considered a good fit. The two founders of Saber Interactive have operational earnouts, for example, they have to release a certain amount of games during a six years period. If they reach these milestones, they get a certain profit-share. The two founders currently own Embracer-shares for SEK 3.5 billion each. The founder of DECA, Ken Go, owns “borrowed” Embracer-shares currently worth SEK 1 billion. He has different financial milestones in a 3 to 7-years period. If he reaches these milestones, he can keep his Embracer shares. In five years he must, for example, reach a certain level of revenues and profitability. Any acquisitions made will be added to milestones but will have a cost-of-capital formula that will be added to the hurdles. In contrast to many other companies, Embracers shareholders will not be further diluted if those entrepreneurs get their full earnouts. However, if they do not deliver according to the terms, shareholders instead will benefit from a stronger balance sheet as compensation. Our view is that Embracer has given the key personnel incentives to obtain growth and certain financial targets through acquisitions. But we do not believe they have incentives to acquire for the sake of its own, but to achieve overall profitability and growth in the company. On the other hand, there is a great driving force to build great companies for these entrepreneurs, which we believe is the primary mission for them. 2 dsfdsf REDEYE Equity Research Embracer Group 15 December 2020 The Market wants a Mega Acquisition Wingefors sees somewhat increased competition amongst small to medium-sized private gaming companies, especially in the PC/Console so-called “premium-segment”, which is the core focus for the company. This often results in higher earnings-multiples in potential acquisitions. Amongst studios with a “free-to-play” business model, often found in online PC- games and mobile games, the competition is lower. Embracer has significant room for a mega acquisition, through the mandate of new shares and a large cash position. Wingefors prefer acquisitions in a private environment. It is more complicated to buy a public company, and the price tag is, in most cases more expensive. We believe Embracer will buy more major studios like Saber Interactive. But it will of course be more complicated to buy/merge with some of the premium class studios like Bungie, Techland, Platinum Games, etcetera. As we all know Microsoft, Tencent, or Epic Games will likely win those targets if the highest price wins. Many a Little makes a Mickle With the latest acquisitions, Embracer has 58 in-house game studios under its umbrella, of which 20 have been added since August this year. We believe Embracer still has much room to grow through small to medium-sized bolt on-acquisitions. And, of course, all former acquisitions will boost growth for many years to come. The risk is also lower in releasing A/AA titles as the investment is lower, and we believe the return on investment is usually higher. The latest SpongeBob release being an excellent example of a game with a relatively small budget but still contributing materially to Embracers sales in the quarter. Flying Wild Hog The most notable acquisition was the Polish game developer “Flying Wild Hog” with its 266 employees and an initial purchase price of USD 137.2 million. The developer, which was acquired by Koch Media, includes the game series Shadow Warrior and Hard Reset. One of the games that the studio is working on was announced during The Game Awards 2020, on December 11, 2020, and is called Evil West. The game is set to release in 2021 and Focus Home Interactive is the publisher. The announcement trailer has amassed almost a million views spread across different YouTube channels. Flying Wild Hog is working on two additional unannounced projects. One of which is going to be published by Jagex. Flying Wild Hog has created two games on the Shadow Warrior IP. The games have sold over 9 million copies, and the sequel Shadow Warrior 3 is planned to be released in 2021. We think this is a great acquisition since it already has a wide pipeline of games. Shadow Warrior is a strong IP, and there is a high probability for the upcoming game to be a success. 3 dsfdsf REDEYE Equity Research Embracer Group 15 December 2020 Purple Lamp Studios THQ Nordic has acquired 100% of the shares in Vienna-based studio, Purple Lamp, onboarding its team of 38 developers. The purchase price consists of a combination of cash and shares, but the acquisition price was not disclosed. The two companies have worked together on multiple projects in the past, including this year’s SpongeBob SquarePants: Battle for Bikini Bottom - Rehydrated and The Guild 3, which currently is in Early Access.