Update Equity Research 2 December 2019 Embracer Group Sector: Gaming Unmotivated share price drop FAIR VALUE RANGE BEAR BASE BULL Beating estimates, again 60.0 100.0 125.0 Embracer crushed our estimates during FY’Q2, the top-line came in 25% above forecast, and Operational EBIT showed a 53% beat. As expected, there was a significant decline in volumes within Partner Publishing, so on an annual basis, the net sales were down 1%. EMBRAC.ST VERSUS OMXS30 However, the Gross profit grew by almost 66%, thanks to the uptake in Games revenue. The OMXS 30 Operational EBIT margin came in at 19% compared to our estimate of 16%. On a trailing- Embracer Group 10.0 twelve -month basis, Embracer has produced almost SEK 2bn in cash flow from operations and continues to show a high cash conversion ratio. 8.0 6.0 Investing for the future 4.0 Embracer continues to invest in its pipeline, and the game investments amounted to SEK 2.0 343m during the quarter. The company now has 86 projects in development, where we 0.0 know that at least two are AAA projects that are expected to be released during the next 03-dec 03-mar 01-jun 30-aug 28-nov financial year. The ratio between released games and ongoing development projects on the balance sheet now amounts to 4x; in other words, continued growth is to be expected. REDEYE RATING Shenmue III was released on the 19th of November. The early user reviews indicate strong receptions from fans but mixed from critics. We find that early data indicates an ok release, 5 in terms of units sold, but no blockbuster. Next up is the PC and Stadia release of 4 4 Darksiders Genesis on the 5th of December. The share price drop is unmotivated People Finance The share price of Embracer Group has shown a poor performance during the past couple Business of months. The drop-in share price was initiated when a negative short analysis was published by the research firm The Analyst. Our conclusion remains unchanged: “As it seems like that the short case rest on a dubious valuation approach, falls claims, weird KEY STATS conclusions, and directly incorrect facts view the share drop as totally unmotivated (nothing Ticker EMBRAC.ST has changed with the business). We reiterate our Base-case valuation of 100 SEK per share. Market Nasdaq FY21 will be a massive year for Embracer as two AAA titles, and many mid-sized games are Share Price (SEK) 68 expected to be released. We argue that 12x our rather conservative Operational EBIT Market Cap (MSEK) 21 147 estimate for next Financial Year is attractive for a company of Embracer’s qualities. In our Net Cash 19E (MSEK) 1429 view, Embracer’s growth prospects, coming margin expansion, and their very strong track- record of value-adding M&A deals should warrant a premium valuation. Free Float 50 % Avg. daily volume (‘000) 750 KEY FINANCIALS (SEKm) 2017 18/19 FY21E FY22E FY23E FY24E Net sales 508 5754 5671 6984 8204 9188 ANALYSTS EBITDA 273 1592 1994 2561 3138 3807 Kristoffer Lindstrom Oper. EBIT 202 880 1167 1600 2034 2486 [email protected] EPS (adj.) 0.62017 1.20182 1.32019E 2.12020E 3.22021E 5.22022E Tomas Otterbeck EV/Sales 19.9 3.2 3.5 2.8 2.4 2.1 [email protected] EV/EBITDA 37.0 11.7 11.6 8.7 7.3 6.9 EV/Op. EBIT 50.0 20.9 16.9 12.3 9.7 7.9 P/E 77.0 59.9 51.5 31.9 20.9 12.9 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 2 December 2019 On the report Estimates vs Outcome Embracer Group FY19- FY20- FY20- Diff % MSEK Q2* Q2 Q2E Net sales 1 273 1 260 1 008 25% of which New releases Games 117 261 249 5% Backlog Games 259 555 310 79% Partner Publishing/Film 897 444 448 -1% Gross profit 377 625 524 19% EBITDA 215 418 313 34% Operational EBIT 99 241 157 53% EBIT 91 77 36 113% Revenue growth -1% -21% Gross profit margin 30% 50% 52% EBITDA margin 17% 33% 31% Opr. EBIT margin 8% 19% 16% EBIT margin 7% 6% 4% Source: Redeye Research *FY19-Q2 w as the third quarter of the extended year 19/20, but for easier comparison, w e call it Q2. Embracer crushed our estimates during FY’Q2, the top-line came in 25% above forecast, and Operational EBIT showed a 53% beat. As expected, there was a significant decline in volumes within Partner Publishing, so on an annual basis, the net sales were down 1%. However, the Gross profit grew by almost 66%, thanks to the uptake in Games revenue. The Operational EBIT margin came in at 19% compared to our estimate of 16%, the higher than expected margin was generated from a lower SG&A then we had projected, likely thanks to the operational leverage from the favorable income mix. Games Games produced net sales of SEK 816m during the quarter, corresponding to annual growth of 69%, despite a relatively few new releases. Digital share amounted to 74%, and owned titles stood for 78% of revenue. Embracer: Sales development Games & sales mix 1200 90% 80% 1000 98 70% 800 45 60% 50% 600 83 794 442 40% % of sales of % 187 Net salesNet (mSEK) 400 30% 373 142 342 338 326 252 20% 200 178 352 330 119 255 10% 138 146 143 185 82 86 85 124 0 0% THQ Nordic Deep Silver Coffee Stain Own IPs % sales Digital % sales Source: Redeye Research 2 REDEYE Equity Research Embracer Group 2 December 2019 What was especially impressive was the substantial backlog sales within Games. The backlog revenue amounted to a whooping SEK 555m, 79% above our projections. Metro Exodus continues to show solid sales figures, Kingdom Come Deliverance, Pathfinder and Outward also had excellent contributions. The company also states that older Dead Island and Saints Row made a nice addition, likely from different bundles and digital sales promotions. Coffee Stain produced strong sales despite no release and relatively little content updates; this shows the strength of their IPs. Embracer: Backlog sales, Finished Games asset & sales return 600 250% 555 524 500 200% 400 386 150% 300 259 254 mSEK 232 100% 200 % salesreturn 145 50% 100 71 52 51 65 0 0% Backlog Finished Games asset % return on released dev asset -1Q Source: Redeye Research Embracer had SEK 393m in finished game asset recorded on the balance sheet et the end of Q2, up from SEK 427m in Q1. When we compare the backlog revenue, and the Q1 reported game asset (which is the asset that produced the backlog sales), we can see that those assets generated a 130% sales return. The sales return % has been increasing since the release of Metro Exodus, thanks to the robust backlog and digital sales of the title. Embracer: New release sales, Finalized dev. & Sales return 900 4.0x 781 800 3.5x 700 3.0x 600 2.5x 500 2.0x 400 mSEK 321 1.5x 300 246 261 Sales return 190 200 1.0x 98 117 117 100 0.5x 30 15 34 0 0.0x New releases per quarter Finalized development Sales return New releases to fin. dev. Source: Redeye Research New releases amounted to SEK 249m during the quarter, mainly driven by; Wreckfest, Switch versions of a Red Faction and a Darksiders game, MXGP2019, some royalties from Remnant, 3 REDEYE Equity Research Embracer Group 2 December 2019 a couple of DLC's and a handful other minor releases. Compared to last year, the new release revenue more than doubled. The company had SEK 101m in finalized and released development, which means that the sales return on finished products amounted to 2.6x during the quarter. The asset of ongoing development amounted to SEK 1 582m at the end of the quarter, up from SEK 1 280m at Q1. The finalized development amounted to 8% of Q1’s recorded asset, an indicator of relatively few releases. We will likely see larger releases during the coming two quarters, which means that the finalized development will be higher and likely also the new release revenue. Embracer: Development asset and % finalized development 1800 16% 1667 1575 1582 1600 14% 1412 1400 1280 12% 1200 1131 1115 10% 1000 8% % mSEK 800 6% 600 4% 400 200 2% 0 0% FY19-Q1 FY19-Q1* FY19-Q2* FY19-Q3* FY19-Q4* FY20-Q1 FY20-Q2 Ongoing development asset Fin. Dev. % of ongoing dev asset -1Q Source: Redeye Research On the quarterly presentation, the management disclosed some interesting figures on the historical gross profit within Games. By using those numbers, we can also calculate the gross profit within Partner Publishing/Film (PP/F). Looking at the last twelve months (t12m), Games produced a gross profit contribution of SEK 2.23bn and PP/F SEK 445m. Embracer: Gross profit per product segment (trailing-twelve-months) Period FY19-Q2* FY19-Q3* FY19-Q4* FY20-Q1 FY20-Q2 T12m net sales Games 1 506 1 803 2 447 2 604 3 044 Gross profit games 927 1 122 1 647 1 913 2 225 Margin 62% 62% 67% 73% 73% T12m PP/F net sales 2 445 2 542 2 674 2 821 2 368 PP/F GP 322 482 534 510 445 Margin 13% 19% 20% 18% 19% Source: Redeye Research The difference in margin levels is apparent, and something investors/readers must be very aware of.