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- 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 Coffee Stain Own IPs % sales Digital % sales

Source: Redeye Research

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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. Exodus continues to show solid sales figures, Kingdom Come Deliverance, Pathfinder and Outward also had excellent contributions. The company also states that older and 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 and a game, MXGP2019, some royalties from Remnant,

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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. The fluctuation in gross profit margin within Games is mostly dependent on how much income is generated from owned titles and digital backlog sales.

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REDEYE Equity Research Embracer Group 2 December 2019

Investments and cash flow Embracer continues to invest in its pipeline, and the game investments amounted to SEK 343m during the quarter. The company now has 86 projects in development, where we know that at least two are AAA projects that are expected to be released during the next financial year. The ratio between released games and ongoing development projects on the balance sheet now amounts to 4x. This means that the non-revenue generating pipeline projects are four times as large as the ones that currently produce an income; in other words, continued growth is to be expected.

Embracer: Net sales, Game CAPEX and Development projects

3500 100 3044 90 3000 2604 80 2447 2500 70 60 2000 1803 1506 50 1500 1214 40

1000 817 30 508 20 500 302 341 374 380 10 0 0

t12m net sales t12m Game CAPEX Development projects

Source: Redeye Research

There has been much discussion about Embracer's cash flow generating capabilities and the use of Operational EBIT as a measure of profits. Overall, we can say that the correlation between the operational cash flow and Oper. EBIT has been high, and on a t12m basis, the cash conversion usually stands close to 100%. NWC shifts, as we saw in FY19'Q3, are most often netted out on a t12m basis. To us, it's clearly visible that Embracer has a healthy business that generates a high amount of cash flow. That the company then chooses to use cash flow for growth investment is positive in our view. The current t12m cash flow amounts to almost 2bn SEK with a cash conversion of nearly 200%.

Embracer: Cashflow from operations, Operational EBIT and cash conversion (t12m)

2500 350%

1958 300% 2000 250%

1500 200%

mSEK 1000 150% 100% 500 50%

0 0% Cash conversion (Oper. EBIT/Oper.CF) Cashconversion (Oper.

t12m Cashflow from operations t12m Operational EBIT Cash conversion

Source: Redeye Research

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REDEYE Equity Research Embracer Group 2 December 2019

PPA and accounting at acquisitions The accounting praxis when Embracer acquires companies can be hard to understand for the average investor. The company presented an explanation in the latest quarterly report presentation:

The most important take-aways are: • The PPA is not only based on the initial purchase price, but also the earn-out. The earn-out is most often paid directly, but with a claw-back right. • The total price is compared to the equity value, the surplus is added to goodwill and IP-rights and the depreciated over five years (In IFRS there is an annual impartment test, not a straight-line depreciation) • The ongoing development is taken over, not added to IP-rights and goodwill.

There were no new major acquisitions announced in conjunction with the report, but six purchases in total were finalized during the period. The two major ones were Milestone and . In addition to the larger ones, there where also a purchase of , GBK Game Invest and a few more within PP/F. A total surplus-value of SEK 1.33bn was recorded and allocated primarily to goodwill and IP-rights. The surplus-value is the amount of PPA that exceeds the net asset value of the companies. Most of the acquired companies have a very asset-light model, which leads to high surplus value. We know what Embracer paid for Milestone and the smaller acquisitions, but not Gunfire and Piranha. We can, however, make a rather good assessment by looking at the surplus level, PPA for Milestone, their equity level pre-acquisition, and knowing that there is a deferred tax included in the PPA.

Deal value and PPA Company Deal value Def. tax PPA Equity* Surplus Milestone 750 165 916 169 747 GBK Game Invest 42 13 55 30 25 Piranha Bytes + Gunfire Games 416 91 508 50 558 Total 1 209 1 330 Source: Redeye Research *Equity level for Piranha and Gunfire is our estimate.

We find it likely that the deal value for Piranha Bytes and Gunfire Games combined amount to roughly SEK 400m, likely the majority of that is for Gunfire.

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REDEYE Equity Research Embracer Group 2 December 2019

Shemue III release Shenmue III was released on the 19th of November. The early user reviews indicate strong receptions from fans. One should note that Shenmue is a niche title with a loyal core audience. Looking at .com, there are 236 user ratings on the PC version and 813 PS4 (2019-11-26). The user score on PS4 amounts to 8.2 and 7.1 on the PC. A lot of comments on PC is regarding the Epic exclusivity, which explains the difference in the score between the two platforms. The following is a word cloud of the first 35 written on PS4 reviews:

Based on the comments, the developer Neilo and Ys Net (game producer Yu Suzuki) seem to have stayed true to the Shenmue style, which fans like. Currently, on the PS4, there have been eight critics reviews with a Metascore of 70.

Highest critic: 90 – IGN Japan: “While the story's climax left us disappointed, Shenmue III is a precious game nonetheless. Feeling the lingering presence of your deceased father in a country far from home, sharing a roof with someone you love, and overcoming the teachings of a stubborn kung fu master are only a few examples of how this game portrays deep human relationships. Shenmue III also has a very addictive gameplay loop that makes great use of the attention to detail the series is known for.”

Lowest critic: 40 – Trusted Reviews: “Shenmue 3 would have been well received in 2003, but we’re 18 years on from the last entry and Shenmue hasn’t budged an inch. If you weld your nostalgia goggles to your face, you’ll be able to slog through the story, but it really is a chore. Poor game design and a complete lack of innovation are the killers, but even the continuation of the story is a meagre offering thanks to ludicrous levels of padding..”

Shenmue I sold about 1.2 million units in its first year; one should note that a much smaller team has built the new installment, so the investment recoup is lower than the older titles. The first game came out in 1999, so the landscape of gaming has changed a lot since then. At the end of 2018, Sega released a remake called Shenmue I & II. According to VGChartz, that game sold 107k physical units during its launch week.

It’s always tough to say anything about the possible sales figures at this point in time. However, Twitch data can be used as a type of indication of consumer interest. The Peak concurrent views on Twitch amounted to roughly 25k on the 20th of November. When the Shenmue I & II game was released, the game had 6k Peak Twitch viewers and launch date

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REDEYE Equity Research Embracer Group 2 December 2019

and topped out at 10k after a few days post-release. To give the figure some more perspective, Darksiders III had roughly 81k Peak concurrent Twitch viewers on launch day. Shenmue III and Darksiders III are very different games, which also make the “stream ability” of the titles different. Another interesting fact is that Shenmue III has remained steady at number three in the top 20 sellers list on Epic Games Store. It’s hard for us to say what that means in terms of units sold, but at least it’s not negative.

The UK Charts report of physical sales in the UK is often one of the first indications of sales progress for a game. Still, the comment by gamesindustry.biz is hard to make any larger conclusion from due to the fact of the large Kickstarter backing of Shenmue III.

”Perhaps not so successful is the release of Shenmue III. The follow-up to the Dreamcast classics comes in at No.17. Only released on PS4, the new release sold a little more than half of last year's Shenmue I and II remaster (PS4 sales only). However, the numbers for this game have been skewed by the fact almost 70,000 gamers backed the title via Kickstarter.” Read full article here.

We find it likely that the sales will be heavily tilted to digital sales, so UK physical likely have somewhat limited predictability for the overall success, according to us. We believe that the user scores indicate that the fans are happy, which is the most important thing. For Embracer, this is a mid-sized release, and we find that the current data available suggest a decent ROI for the company but no block-buster success.

Games coming to market

Embracer has a lot in its pipeline, of which many titles are still unannounced. We have listed the games we know of as of today. Some of the release dates are still unconfirmed, so that is just our estimates. Title Est. release date Quarter Publisher IP owner Platforms Sales chanel Cooking Simulator 2019-10-01 FY20'Q3 Ravenscourt External PC Offline Little Big Workshop 2019-10-17 FY20'Q3 HandyGames Own PC Online Let's sing Country 2019-10-25 FY20'Q3 Ravenscourt External PS4, , Switch On- & Offline Let's Sing 2020 2019-11-05 FY20'Q3 Ravenscourt External PS4, Switch On- & Offline Shenmue III 2019-11-19 FY20'Q3 Deep Silver External PC, PS4 On- & Offline 9 Monkeys of Shaolin 2019-12-01 FY20'Q3 Ravenscourt External PC, PS4, Xbox One, Switch On- & Offline Darksiders: Genesis 2019-12-01 FY20'Q3 THQ Nordic Own PC, Stadia On- & Offline DCL - The Game (unconfirmed) 2019-12-02 FY20'Q3 THQ Nordic External PC, PS4, Xbox One, Switch On- & Offline Metro Exodus - Sam's Story (DLC) 2020-01-01 FY20'Q4 Deep Silver Excl. lic. PC, PS4, Xbox One On- & Offline Pathfinder: Kingmaker (unconfirmed) 2020-02-01 FY20'Q4 Deep Silver External PS4, Xbox One, Switch On- & Offline Darksiders: Genesis 2020-02-01 FY20'Q4 THQ Nordic Own PS4, Xbox One, Switch On- & Offline Destroy All Humans! (unconfirmed) 2020-02-01 FY20'Q4 THQ Nordic Own PC, PS4, Xbox One On- & Offline Monster Energy Supercross 3 2020-02-04 FY20'Q4 Milestone External PC, PS4, Xbox One On- & Offline Biomutant (unconfirmed) 2020-03-01 FY20'Q4 THQ Nordic Own PC, PS4, Xbox One On- & Offline Comanche (unconfirmed) 2020-03-01 FY20'Q4 THQ Nordic Own PC Online Iron Harvest 2020-09-01 Deep Silver External PC, PS4, Xbox One On- & Offline El Hijo TBC FY20 HandyGames External PC, PS4, Xbox One, Switch Online One Hand Clapping TBC FY20 HandyGames External PS4, Xbox One, Switch Online Spitlings TBC FY20 HandyGames External PC, PS4, Xbox One, Switch Online Through the Darkest of Times TBC FY20 HandyGames Own PC On- & Offline Townsmen VR (full) TBC FY20 HandyGames Own PC, PS4 Online Cooking Mama Cook Star TBC FY20 Ravenscourt External PS4, Switch On- & Offline Aquanox Deep Descent TBC FY20 THQ Nordic Own PC, PS4, Xbox One On- & Offline Pillars of Eternity II - Deadfire TBC FY20 THQ Nordic External PS4, Xbox One Offline Spongebob Squarepants: Rehydrated TBC FY20 THQ Nordic External PC, PS4, Xbox One, Switch On- & Offline The Guild 3 TBC FY20 THQ Nordic Own PC On- & Offline Knights of Honor II: Sovereign TBC FY20 THQ Nordic Own PC On- & Offline Desperados 3 (unconfirmed) TBC FY21 THQ Nordic Own PC, PS4, Xbox One On- & Offline Satisfactory (full) TBC FY21 Coffee Stain Own PC Online Songs of Conquest TBC FY21 Coffee Stain Own PC Online Midnight Ghost Hunt TBC FY21 Coffee Stain External PC Online Dead Island 2 TBC FY21 Deep Silver Own PC, PS4, Xbox One On- & Offline Wasteland 3 TBC FY21 Deep Silver External PC, PS4, Xbox One On- & Offline Scarf TBC FY21 THQ Nordic External PC Online A Rat's Quest TBC FY22 HandyGames External PS4, Xbox One, Switch Online Source: Redeye Research

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REDEYE Equity Research Embracer Group 2 December 2019

Q3 projections

Detailed estimates THQ Nordic (Group) Quarterly projections Yearly projections Period FY20-Q1 FY20-Q2 FY20-Q3E FY20-Q4E FY20E FY21E FY22E Net sales 1142 1260 1373 1896 5671 6984 8204 Of which New releases games 117 261 353 703 1434 2079 2494 Backlog games 524 555 440 419 1938 2423 3029 Partner Publishing/Film 501 444 580 774 2298 2482 2681 Other income 176 244 195 270 884 928 975 CoS -528 -635 -668 -870 -2701 -3156 -3552 Gross profit 614 625 705 1026 2969 3828 4652 Other OPEX -178 -192 -192 -265 -827 -1048 -1231 Staff cost -223 -258 -247 -303 -1032 -1187 -1313 EBITDA 389 418 460 726 1994 2521 3083 Depreciation -185 -177 -189 -275 -827 -921 -1049 Op. EBIT 204 241 271 452 1167 1600 2034 Amortization -123 -164 -162 -164 -613 -710 -692 EBIT 81 77 109 288 554 891 1342

Gross profit margin 54% 50% 51% 54% 52% 55% 57% EBITDA margin 34% 33% 34% 38% 35% 36% 38% Op. EBIT margin 18% 19% 20% 24% 21% 23% 25% EBIT margin 7% 6% 8% 15% 10% 13% 16% Source: Redeye Research

For FY20’Q3, we expect that the Group net sales will reach SEK 1373m with an Operational EBIT of SEK 271m. Compared to our last research update, we have not made any more substantial forecast changes to our Q3 and Q4 estimates.

Key drivers:

• Games: o New releases. We believe new releases will generate revenues of SEK 353m. The more significant titles that will be released are on PC/Stadia and the Shenmue III (that we discussed about earlier); there will also be 5-8 other new games launched (like "Let's sing"). At Q2 end, Embracer had SEK 1.6bn in ongoing development assets, and we expect that 10% of that will be finalized and create a sales return of roughly 2.2x. In the corresponding quarter last year, the company released Darksiders III and produced a new release revenue of SEK 320m. We believe this year's line-up will create a slightly higher income level, mostly driven by the fact that there more mid-sized releases. o Backlog: Q3 for Embracer is the last quarter of the calendar year, and also the high-season of gaming. We expect that the backlog sales continue to remain strong with the contribution of Metro Exodus with DLC’s, Stadia, digital bundles, sales packages, Satisfactory, and more. We expect that games will have a backlog sales of SEK 440m, this corresponds to a growth of 90% compared to the same period last year. Our assumption implies a 112% sales return on the finished and completed games asset that was recorded at Q2 end. • Partner Publishing: There won’t be any significant AAA games released for Partner Publishing during Q3. We expect to see a drop compared to last year but at the same time, a likely sequential increase thanks to seasonality and the release of Sega Mega Drive Mini. Q4’FY20 and Q1’FY21 (calendar H1 2020) will likely show stronger sales figures as more AAA releases are expected. We expect to see a revenue level of roughly SEK 580m, a 30% drop compared to last year. • Profitability: We expect healthy gross margins thanks to the significant contribution of own titles and digital sales of the backlog. The relatively low PP/F share of the revenue mix also contributes to strong margins. Our assumptions lead to an Operational EBIT margin of 20%.

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REDEYE Equity Research Embracer Group 2 December 2019

Valuation

The share price of Embracer Group have shown a poor performance during the past couple of months. The drop-in share price was initiated when a negative short analysis was published by the research firm The Analyst. A lot of questions arose from investors and we presented our view in a research update which can be found here.

Our conclusion was the following: “As it seems like that the short case rest on a dubious valuation approach, falls claims, weird conclusions, and directly incorrect facts view the share drop as totally unmotivated (nothing has changed with the business). In our view, the decline in share price has led to an attractive opportunity for long-term investors to invest in a genuinely quality growth company at attractive levels”.

Our view has not changed, and we reiterate our Base-case valuation of 100 SEK per share. Current valuation level indicates a 17x multiple of FY20 Operational EBIT. FY21 will be a massive year for Embracer as two AAA titles and many mid-sized games is expected to be released. We argue that 12x our rather conservative Operational EBIT estimate for next Financial Year is attractive for a company of Embracer’s qualities. Our Base-case indicates a 18x multiply, slight above the peer group valuation levels. In our view, Embracer should have a premium valuation thanks to growth prospects, coming margin expansion and their very strong track-record of value-adding M&A deals. Peer valuation EV/Sales EV/(Op.)EBIT S. CAGR EBIT margin Company EV (MSEK) FY20E FY21E FY20E FY21E FY22E 18-21E FY20E FY21E FY22E

Nordic Gaming

Paradox Interactive 13 875 10.5x 8.2x 29.1x 21.3x 18.2x 20% 36% 39% 40% Stillfront 9 712 4.9x 3.9x 17.8x 13.0x 10.8x 28% 27% 30% 32% Remedy 1 141 2.8x 3.3x 8.5x 15.3x 12.3x 27% 33% 21% 22% Funcom 877 3.4x 2.9x 44.6x 18.3x 6.1x 23% 8% 16% 26%

Starbreeze 849 3.1x 4.4x n.m. n.m. 11.0x 2% -121% -11% 21% Atari 752 2.2x 1.9x 18.1x 14.4x 10.4x 40% 12% 13% 15% G5 Entertainment 735 0.6x 0.5x 11.6x 7.0x 5.3x 3% 5% 7% 9% Median 877 3.1x 3.3x 18x 15x 11x 23% 12% 16% 22% Mobile/casual Zynga 49 728 3.4x 2.9x 20.5x 16.5x 14.0x 33% 17% 18% 19% GLU 6 591 1.6x 1.5x 20.2x 16.4x 7.8x 18% 8% 9% 16% Com2us 4 801 1.2x 1.1x 4.6x 3.9x 3.6x 8% 27% 27% 28% Rovio 2 325 0.7x 0.7x 10.3x 7.3x 6.2x 7% 7% 10% 11% Atari 752 2.2x 1.9x 18.1x 14.4x 10.4x 40% 12% 13% 15% G5 Entertainment 735 0.6x 0.5x 11.6x 7.0x 5.3x 3% 5% 7% 9% Next Games 253 0.7x 0.5x -3.2x -6.5x 412.7x 25% -21% -8% 0% MAG Interactive 237 1.2x 1.1x n.m. n.m 9.2x 4% 3% 9% 11% Median 1 538 1.2x 1.1x 12x 7x 8x 13% 8% 9% 13% International Gaming Tencent 3 943 757 6.2x 5.1x 22.2x 17.9x 17.1x 21% 28% 28% 25%

Nintendo 395 762 3.5x 3.3x 14.2x 12.1x 13.3x 13% 25% 27% 26% Activision 380 307 6.2x 5.7x 19.0x 16.2x 13.8x 4% 33% 36% 38% EA 245 435 4.9x 4.8x 15.8x 15.2x 13.9x 10% 31% 31% 31% Take-Two 118 247 4.3x 4.3x 21.3x 21.5x 15.8x 33% 20% 20% 21%

Bandai Namco 110 652 1.7x 1.6x 13.4x 12.4x 11.5x 13% 12% 13% 13% Ubisoft 75 393 4.6x 2.8x 51.2x 12.8x 12.4x 18% 9% 22% 22% CD projekt 60 376 7.3x 11.0x 10.7x 14.0x 18.5x 67% 68% 79% 69% Median 181 841 4.8x 4.6x 17x 15x 14x 16% 26% 28% 25% Peer Group median 91 359 3.9x 3.9x 18x 15x 12x 19% 19% 22% 24% Embracer Group 19 718 3.5x 2.8x 17x 12x 10x 13% 21% 23% 25%

Source: Bloomberg & Redeye Research 10

REDEYE Equity Research Embracer Group 2 December 2019

Investment Case

The acquisition of is a prime example of Embracer Group's acquisition strategy and why we continue to be positive to the case. We believe that the market is still to fully grasp the underlying value and cash flow generating capabilities of Embracer's growing IP portfolio, which was enhanced to a significant degree following the purchase of the European publisher.

We believe that the markets overall low understanding of the Gaming industry and focus on the short-term creates an opportunity for the investor who see the bigger picture in Embracer. The following bullet points summarize our investment thesis;

• The company showed significant growth during 2017 but a large part of the IP portfolio is still not generating any income, this will change in the coming years

• Embracer’s IP portfolio grew significantly following acquiring Koch Media, the asset care possibilities and thus value enhancement is vast

• Owner operator with a highly skilled management team with the right focus on long-term value creation

• The core strategy is to acquire IPs at depressed prices and then enhancing their value, Koch Media acquisition as a prime example

A large part of the asset value is still untapped he company showed significant growth during 2017, but a large part of the IP portfolio is still not generating any income. Development projects including a few AAA will be released in the years to come. This will take revenues and the profits to entirely new levels.

Embracer's IP portfolio grew significantly following acquiring Koch Media. We believe that the company will use its asset care expertise and unlock a lot of value from the long tail part o0f the game asset in the coming years. Some key franchises included in the IP portfolio are Darksiders, MX vs. ATV, Red Faction, Delta Force, , SpellForce, Saints Row, Dead Island, Metro and 100+ more.

Focus on long-term value and buying cheap Embracer Group is what we like to call an owner-operator company where the management team owns 50%+ of capital, has extensive experience from the industry and is highly committed to building “something big.” We believe there should be a premium on the valuation because of the strong shareholder focus

Embracer's core strategy is to acquire IPs at depressed prices and then enhancing their value. We view the Koch Media acquisition as a prime example of this approach. This focus will continue to keep risks at low levels and create significant investment returns for shareholders going onwards Many public companies suffer from a short-term quarterly focus; this could not be further from the case when it comes to Embracer. We find the long-term thinking as a distinct advantage; we also believe this way of business will further increase following the Koch acquisition as the company will be less dependent on single releases for cash flow.

Our forecast, and therefore also our DCF valuation, does not factor in possible future value-adding acquisitions of IPs or companies, but it is a fact that Embracer will continue to acquire, and will do so with bravura

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REDEYE Equity Research Embracer Group 2 December 2019

Counterarguments (Bear-points)

It is always sensible to develop some counterarguments to an investment thesis. Below, we present some bear- points that an investor should consider and have in mind if the future development is not favorable.

• Title risks of larger releases – Despite Embracer’s extensive portfolio there is always some title risk when releasing larger projects. Disappointing releases and/or reviews could dampen investors’ enthusiasm and hurt the company’s financials. • Rising competition in bidding for acquisitions – As Embracer is entering a new level as a company, so will the future acquisitions in terms of size and target reputation. Going from an unknown player to a more established company might make it harder to find cheap deals. • Management is paramount – Just as much we love a strong and committed management team, it is also a fact that relying on a few key individuals also poses a risk.

Valuation range

Bear Case 60.0 SEK Base Case 100.0 SEK Bull Case 125.0 SEK Key model assumptions: Key model assumptions: Key model assumptions: CAGR of 6% during forecast period CAGR of 9% during forecast period CAGR of 11% during forecast period Average Op. EBIT margin of 16% Average Op. EBIT margin of 21% Average Op. EBIT margin of 24% Terminal growth 2% Terminal growth 2% Terminal growth 2% Terminal Op. EBIT margin of 15% Terminal Op. EBIT margin of 23% Terminal Op. EBIT margin of 25%

In our Bear-case, we have used In our Base-case scenario, we In our Bull-case we assume a larger much more conservative model that the investment in new success for the upcoming major assumptions regarding the success releases continues at a high phase releases during 2018, 2019 and of the larger upcoming releases. We the coming years. The size, 2020 the company then reinvest also model a much slower growth regarding income, of the company, those cash flows into even greater long-term of new release revenue, has increased significantly following projects, which also works out well. as in this scenario the earlier the Koch Media acquisition, and the In this scenario, some sales and disappointments makes the Group now has a huge partner cost synergies between Koch Media company more cautious of new publishing business. Profitability and the “old” THQ Nordic creates larger projects. However, the wise we believe it is possible that higher margins and sales growth. catalog revenue continues to the gross margins will expand as Our assumptions in the Bull-case develop at a healthy pace. The lower the revenue streams from the own regarding commercial success for assumed growth leads to less IPs will grow faster than the the larger upcoming releases should operational leverage, and we model publishing revenue and that the not be seen as any “Blue-sky” a less aggressive margin uptake and Group turns their profitable asset scenario with overly positive that no real synergies between Koch care focus on Koch Media IP asset. estimates. Media and THQ Nordic manifest. There is of course also the inherent scalability of Embracer Group’s business model that will come into play.

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REDEYE Equity Research Embracer Group 2 December 2019

Catalysts

More value adding acquisitions

Embracer Group has a strong focus on acquiring IPs, franchises, and companies at low prices. They can do this by utilizing one of the best characteristics of a great investor; patience. Larger acquisitions of well-known IPs could and should enhance the valuation of the company.

AAA titles from Deep Silver and secret project announced

Deep Silver was a part of the Koch Media acquisition. Two studios within Deep Silver is currently developing two AAA titles, one is a new Saints Row game and the other one is unknown, but they will be released in FY21. The announcement of the unknown game would enhance the visibility of the IP portfolio and likely increase the valuation. One of the large development projects from THQ Nordic remains undisclosed. This title has the same type of budget as Darksiders 3 have, which should imply a similar sales potential.

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REDEYE Equity Research Embracer Group 2 December 2019

Summary Redeye Rating

The rating consists of three valuation keys, each constituting an overall assessment of several factors that are rated on a scale of 0 to 1 points. The maximum score for a valuation key is 5 points.

Rating changes in the report

People: 5

The management team of Embracer Group is by our measures highly competent with extensive experience from the Gaming industry. The company continuously puts emphasis on a shareholder focus to generate long-term value creation by keeping to their core strategy; acquiring IPs at the cheap and increase their value by asset care. Lars Wingefors, the CEO and co-founder, is an entrepreneur by heart; he started his first business at the age of 13 and has been selling video games for more than 20 years. We find the management of Embracer as trustworthy as they have never tried to misguide the market; instead, they always make conservative statements and educate the market about their business. The ownership structure of Embracer Group is, in our view, one of its key strengths. All the key personnel has substantial holdings in the company with the co-founder Lars Wingefors controlling more than 50% of the votes. The significant holdings create a focus on long-term value creation and not meeting short- term financial goals that a company led by “hired guns.” In addition to the substantial holdings of the management team, some of the most renowned institutional owners show up on the shareholder's list of Embracer Group.

Business: 4

Embracer Group has an extensive portfolio of game franchises with multiple streams of income and a massive player base. Some of the IPs, like Darksiders, Spellforce, Red Faction and MX vs. ATV, Saints Row, Dead Island, and Metro has a large following and good reputation in the gamer community; this creates a pricing power and demand for new products. Following the acquisition of Koch Media, Embracer has become a power-house, but as the gaming industry is so massive, they are still a relatively small player. The Partner Publishing business has lower margins than “Games”, but still generates a substantial EBIT contribution and acts as a “funnel” for further business development relationships and possible acquisitions.

Financials: 4

Embracer is a company with a strong cash position. One of the company’s core strategies is to acquire game IPs from companies in financial distress; this has led to a conservative approach regarding putting on debt. The income streams are diversified with a large portfolio of IPs and different games. Overall the industry is not sensitive to the business cycle which dampens the financial risk of downturns. During the past years, Embracer has been growing heavily and still producing more than satisfying margins and return on asset. The future profitability levels will vary due to game release schemes as the business model inherits a high degree of scalability. Long-term increasing margins as the company continue to grow and the revenue streams from their own IPs increase even further.

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REDEYE Equity Research Embracer Group 2 December 2019

INCOMEPlease STATEMENT comment on2017 the changes18/19 FY20 in ERating FY21 factors……E FY22E Net sales 508 5,754 5,671 6,984 8,204 Total operating costs -235 -4,162 -3,676 -4,423 -5,066 EBITDA 273 1,592 1,994 2,561 3,138 Depreciation 0 -23 -27 -40 -55 Amortization -84 -995 -1,413 -1,630 -1,741 Impairment charges 0 0 0 0 0 EBIT 188 575 554 891 1,342 Share in profits 0 0 0 0 0 Net financial items -6 -33 -23 -35 -40 Exchange rate dif. 0 0 0 0 0 Pre-tax profit 182 542 532 856 1,302 PROFITABILITY 2017 18/19 FY20E FY21E FY22E Tax -43 -183 -124 -199 -303 ROE 20% 11% 7% 10% 14% Net earnings 139 359 408 656 998 ROCE 26% 17% 8% 11% 15% ROIC 91% 129% 20% 26% 44% BALANCE SHEET 2017 18/19 FY20E FY21E FY22E EBITDA margin 54% 28% 35% 37% 38% Assets EBIT margin 37% 10% 10% 13% 16%

Current assets Net margin 27% 6% 7% 9% 12% Cash in banks 627 2,929 4,238 5,225 5,232 Receivables 90 1,297 1,588 1,397 1,641 DATA PER SHARE 2017 18/19 FY20E FY21E FY22E Inventories 30 323 340 419 492 EPS 1.75 3.50 1.33 2.13 3.24 Other current assets 0 0 0 0 0 EPS adj 1.75 3.50 1.33 2.13 3.24 Current assets 747 4,549 6,166 7,041 7,365 Dividend 0.00 0.00 0.00 0.64 1.30 Fixed assets Net debt -7.89 -28.58 -8.90 -12.11 -12.13 Tangible assets 8 156 229 312 402 Total shares 79.36 102.49 307.70 307.70 307.70 Associated comp. 0 0 0 0 0 Investments 0 0 0 0 0 VALUATION 2017 18/19 FY20E FY21E FY22E Goodwill 24 0 0 0 0 EV 10,087.2 18,594.7 71,480.2 70,492.7 70,486.3 Cap. exp. for dev. 0 1,887 1,774 1,064 373 P/E 77.0 59.9 182.0 113.1 74.3 O intangible rights 541 1,820 2,631 3,498 5,004 P/E diluted 77.0 59.9 182.0 113.1 74.3 O non-current assets 0 196 230 230 230 P/Sales 21.1 3.7 13.1 10.6 9.0 Total fixed assets 573 4,059 4,863 5,104 6,009 EV/Sales 19.9 3.2 12.6 10.1 8.6 Deferred tax assets 2 0 0 0 0 EV/EBITDA 37.0 11.7 35.8 27.5 22.5 Total (assets) 1,322 8,608 11,029 12,145 13,374 EV/EBIT 53.6 32.4 129.0 79.2 52.5 Liabilities P/BV 10.0 3.8 12.1 11.0 9.8 Current liabilities SHARE PERFORMANCE GROWTH/YEAR 16/18E Short -term debt 0 0 1,500 1,500 1,500 1 month - Net sales 234.3 % Accounts payable 208 2,018 1,985 2,444 2,871 3 month 99,999,999,900.-1.2 % Operating profit adj 71.6 % O current liabilities 0 0 0 0 0 12 month 47.60 % EPS, just -13.1 % Current liabilities 208 2,018 3,485 3,944 4,371 Since start of the year 67.0 % Equity 138.8 % Long-term debt 0 0 0 0 0 SHAREHOLDER STRUCTURE % CAPITAL VOTES O long-term liabilities 0 211 211 211 211 Lars Wingefors 35.1 % 51.5 % Convertibles 0 0 0 0 0 Swedbank Robur Fonder 9.1 % 5.1 % Total Liabilities 208 2,229 3,696 4,155 4,582 Erik Stenberg 7.6 % 11.2 % Deferred tax liab 37 0 0 0 0 Handelsbanken Fonder 5.7 % 3.2 % Provisions 4 667 1,214 1,214 1,214 CMB Holding AB 2.6 % 3.8 % Shareholders' equity 1,073 5,712 6,120 6,776 7,577 Första AP-fonden 2.3 % 1.3 % Minority interest (BS) 0 0 0 0 0 Didner & Gerge Fonder 2.2 % 1.2 % Minority & equity 1,073 5,712 6,120 6,776 7,577 Skandinaviska Enskilda Banken S.A 2.2 % 1.2 % Total liab & SE 1,322 8,608 11,029 12,145 13,374 SEB Fonder 2.2 % 1.2 % Familjen Olsson med stiftelse 2.2 % 1.2 % FREE CASH FLOW 2017 18/19 FY20E FY21E FY22E SHARE INFORMATION Net sales 508 5,754 5,671 6,984 8,204 Total operating costs -235 -4,162 -3,676 -4,423 -5,066 Reuters code EMBRAC.ST Depreciations total -84 -1,018 -1,440 -1,670 -1,796 List EBIT 188 575 554 891 1,342 Share price 241.2 Taxes on EBIT 0 0 0 0 0 Total shares, million 307.7 NOPLAT 188 575 554 891 1,342 Market Cap, MSEK 74218.2 Depreciation 84 1,018 1,440 1,670 1,796 Gross cash flow 273 1,592 1,994 2,561 3,138 MANAGEMENT & BOARD Change in WC 73 310 -341 572 110 CEO Lars Wingefors Gross CAPEX -425 -4,504 -2,245 -1,911 -2,701 CFO Johan Ekstöm Free cash flow -79 -2,601 -591 1,222 547 IR Chairman Kicki Wallje-Lund CAPITAL STRUCTURE 2017 18/19 FY20E FY21E FY22E Equity ratio 81% 66% 55% 56% 57% FINANCIAL INFORMATION

Debt/equity ratio 0% 0% 25% 22% 20%

Net debt -627 -2,929 -2,738 -3,725 -3,732

Capital employed 447 2,783 3,382 3,050 3,845

Capital turnover rate 0.4 0.7 0.5 0.6 0.6

ANALYSTS GROWTH 2017 18/19 FY20E FY21E FY22E Redeye AB Kristoffer Lindstrom Mäster Samuelsgatan 42, 10tr Sales growth 68% 1,034% -1% 23% 17% [email protected] 111 57 Stockholm EPS growth (adj) 76% 100% -62% 61% 52%

Tomas Otterbeck [email protected]

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REDEYE Equity Research Embracer Group 2 December 2019

Redeye Rating and Background Definitions

Company Quality

Company Quality is based on a set of quality checks across three categories; PEOPLE, BUSINESS, FINANCE. These are the building blocks that enable a company to deliver sustained operational outperformance and attractive long- term earnings growth. Each category is grouped into multiple sub-categories assessed by five checks. These are based on widely accepted and tested investment criteria and used by demonstrably successful investors and investment firms. Each sub-category may also include a complementary check that provides additional information to assist with investment decision-making. If a check is successful, it is assigned a score of one point; the total successful checks are added to give a score for each sub-category. The overall score for a category is the average of all sub-category scores, based on a scale that ranges from 0 to 5 rounded up to the nearest whole number. The overall score for each category is then used to generate the size of the bar in the Company Quality graphic.

People

At the end of the day, people drive profits. Not numbers. Understanding the motivations of people behind a business is a significant part of understanding the long-term drive of the company. It all comes down to doing business with people you trust, or at least avoiding dealing with people of questionable character. The People rating is based on quantitative scores in seven categories: Passion, Execution, Capital Allocation, Communication, Compensation, Ownership, and Board.

Business

If you don’t understand the competitive environment and don’t have a clear sense of how the business will engage customers, create value and consistently deliver that value at a profit, you won’t succeed as an investor. Knowing the business model inside out will provide you some level of certainty and reduce the risk when you buy a stock. The Business rating is based on quantitative scores grouped into five sub-categories: Business Scalability, Market Structure, Value Proposition, Economic Moat, and Operational Risks.

Financials

Investing is part art, part science. Financial ratios make up most of the science. Ratios are used to evaluate the financial soundness of a business. Also, these ratios are key factors that will impact a company’s financial performance and valuation. However, you only need a few to determine whether a company is financially strong or weak. The Financial rating is based on quantitative scores that are grouped into five separate categories: Earnings Power, Profit Margin, Growth Rate, Financial Health, and Earnings Quality.

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REDEYE Equity Research Embracer Group 2 December 2019

Redeye Equity Research team

Management Editorial Björn Fahlén Jim Andersson [email protected] [email protected]

Håkan Östling Eddie Palmgren [email protected] [email protected]

Technology Team Mark Sjöstedt [email protected] Jonas Amnesten [email protected] Johan Kårestedt (Trainee) [email protected] Henrik Alveskog [email protected] Life Science Team

Dennis Berggren Anders Hedlund [email protected] [email protected]

Havan Hanna Arvid Necander [email protected] [email protected]

Kristoffer Lindström Erik Nordström [email protected] [email protected]

Fredrik Nilsson Klas Palin [email protected] [email protected]

Tomas Otterbeck Jakob Svensson [email protected] [email protected]

Eddie Palmgren Ludvig Svensson [email protected] [email protected]

Oskar Vilhelmsson Oscar Bergman [email protected] [email protected]

Viktor Westman [email protected]

Linus Sigurdsson (Trainee) [email protected]

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REDEYE Equity Research Embracer Group 2 December 2019

Disclaimer Important information Redeye AB ("Redeye" or "the Company") is a specialist financial advisory boutique that focuses on small and mid-cap growth companies in the Nordic region. We focus on the technology and life science sectors. We provide services within Corporate Broking, Corporate Finance, equity research and investor relations. Our strengths are our award-winning research department, experienced advisers, a unique investor network, and the powerful distribution channel redeye.se. Redeye was founded in 1999 and since 2007 has been subject to the supervision of the Swedish Financial Supervisory Authority. Redeye is licensed to; receive and transmit orders in financial instruments, provide investment advice to clients regarding financial instruments, prepare and disseminate financial analyses/recommendations for trading in financial instruments, execute orders in financial instruments on behalf of clients, place financial instruments without position taking, provide corporate advice and services within mergers and acquisition, provide services in conjunction with the provision of guarantees regarding financial instruments and to operate as a Certified Advisory business (ancillary authorization).

Limitation of liability This document was prepared for information purposes for general distribution and is not intended to be advisory. The information contained in this analysis is based on sources deemed reliable by Redeye. However, Redeye cannot guarantee the accuracy of the information. The forward-looking information in the analysis is based on subjective assessments about the future, which constitutes a factor of uncertainty. Redeye cannot guarantee that forecasts and forward-looking statements will materialize. Investors shall conduct all investment decisions independently. This analysis is intended to be one of a number of tools that can be used in making an investment decision. All investors are therefore encouraged to supplement this information with additional relevant data and to consult a financial advisor prior to an investment decision. Accordingly, Redeye accepts no liability for any loss or damage resulting from the use of this analysis.

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Recommendation structure Redeye does not issue any investment recommendations for fundamental analysis. However, Redeye has developed a proprietary analysis and rating model, Redeye Rating, in which each company is analyzed and evaluated. This analysis aims to provide an independent assessment of the company in question, its opportunities, risks, etc. The purpose is to provide an objective and professional set of data for owners and investors to use in their decision-making.

Redeye Rating (2019-12-02) Rating People Business Financials

5p 11 11 2

3p - 4p 84 64 28

0p - 2p 10 30 75

Company N 105 105 105

Duplication and distribution This document may not be duplicated, reproduced or copied for purposes other than personal use. The document may not be distributed to physical or legal entities that are citizens of or domiciled in any country in which such distribution is prohibited according to applicable laws or other regulations. Copyright Redeye AB.

CONFLICT OF INTERESTS

Kristoffer. Lindstrom. owns shares in the company Embracer Group: Yes Tomas. Otterbeck. owns shares in the company Embracer Group: Yes Redeye performs/have performed services for the Company and receives/have received compensation from the Company in connection with this.

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