Game Digital — Game on for BELONG

GMD has continued to perform well in a challenging market. EBITDA for the full year was £10.1m, a 26% rise against FY17, and in line with pre-close guidance. The second half, encompassing the spring and summer, is seasonally weaker. However, the EBITDA second-half loss was £4.2m better than in FY17, more than negating the £2.1m shortfall in the first half.

GTV declined by 1.4% in H2, halving the growth of H1:

Content GTV grew by 4.5% in H2, although the swing towards digital sales intensified, with digital console sales up 33% driving total digital growth of 23%, while physical sales declined in H2, eliminating their 3% first-half growth to end flat for the year. The swing has been led by the popularity of Fortnite, the cult battleground contest; although we assume the growth in digital content sales will not reverse. Within physical sales, a decline in Xbox product was replaced by increased demand for Nintendo Switch content.

Pre-owned sales were affected by the increasing age of Xbox One and 360, and Playstation 3 and even 4, and of personal budgets moving towards digital product, with a 13.7% decline in H2. Accessories and Other (excluding Events, E-sports & Digital) had a more balanced performance in H2 particularly attributable to the demand for headsets driven by Fortnite.

Hardware sales grew only 2% in the second half against 24% in the first, when Nintendo Switch, Xbox One X and Playstation 4 had combined to create a one-off increase.

Events & Esports grew annual GTV by 40.2% to £12.2m on an underlying basis.

Gross margin improved in H2, while continuing to lag FY17:

Content margin in the second half ran behind FY17 as it did in the first, reflecting the higher mix of digital, although pre-owned product, the highest margin category, held its margin. Accessories and Other (excluding Events, Esports & Digital) reversed its first-half improvement reflecting the changing product mix, while hardware improved slightly on an already strong H1 margin driven by the high mix of recent releases. Events, Esports & Digital, while still small, continued to strengthen reflecting the growing BELONG constituent.

Net savings increased beyond the £1.9m of H1, to £9.5m in H2. Underlying UK cost savings banked £6m in H2 on top of the £5m in H1 as a result of lease negotiations, payroll and other efficiencies. That was augmented by a full period without Multiplay, which had only been absent for two months of H1. The translation of Spanish costs was less adverse in H2, increasing from a £1.0m effect in H1 to £1.3m for the full year.

Full-year results exacerbated the tendency seen in FY17 whereby Spain has become the major earner of EBITDA for the group:

UK retail GTV declined 1.1% year-on-year, although within that the swing to digital product and relative strength of hardware, at the expense of physical content and pre-owned product, led to a 2-point fall in gross margin. Nevertheless, UK margins recovered in the second half, reflecting strengthening margins in Pre-owned and Accessories & Other. Cost savings initiatives were focused in the UK and their effect was to reduce profit slippage in H2 to leave EBITDA down £1.3m at £0.5m for the year, compared with a £3.5m y-o-y shortfall at H1.

In Spain strength in sales of hardware and digital led to GTV growth of 7.1% in the full year, although second half growth was only marginal at 0.6%, reducing the first half’s 11.2%. Lower margin category shift also resulted in a one-point gross margin reduction, spread more or less evenly across the year. Nevertheless, growth was sufficient to leave EBITDA only £0.5m behind FY17 at £11.7m.

The BELONG esports arena concept (see https://www.belong.gg/ ) originated in GMD stores but is now the subject of a collaboration agreement with SPD. The initiative is designed to position BELONG as national market leader in local and regional e-sports. Since the collaboration agreement was signed in February, including a substantial £55m financing package, the roll-out of BELONG has been management’s key strategic objective.

In its existing 21 sites the concept has demonstrated high occupancy, high margin and low capex contributing to year 3 ROI (GMD share) of 48%.

In our detailed September note, Part of the retail answer, we set out our forecast for BELONG, which follows the business model described at the interim results in March 2018. In it, we assume 20 openings weighted to the second half of FY19, rising to 29 in subsequent years, at an average size of 35 desks per location (GMD’s target is 40 desks). This results in the total number of stations rising from 368 at end FY18 to c 1,000 at FY19 and 2,000 at FY20.

The scope of the agreement, the scale of new SPD developments, the dynamics of the retail property market and the need to co-ordinate with SPD’s process, together brought some initial inertia. However, detailed planning has now been completed and the first two arenas following the agreement opened in Westfield Stratford in August and Lakeside Thurrock in October.

Achievement of the forecast assumes continued engagement by SPD management and there is no change in our assumptions or GMD management’s expectations in this regard. Clearly SPD management is occupied on several fronts. However, its development objectives have a large degree of commonality with GMD’s.

GMD is able to take advantage of a flexible lease profile to renegotiate leases, relocate or close stores. Its UK store optimisation programme is focused on reducing fixed occupancy costs, lowering operating costs and capitalising on growth potential in major cities and towns. As a result of the formation of the UK company in 2014 and subsequent lease negotiations, there are over 200 potential lease events by the end of 2019. Savings of 42% have been realised from leases renegotiated in FY18 and at July 2018 there were 25 stores on zero rent and 99 on flexible arrangements, usually a three-month rolling break option. This real estate profile is clearly advantageous to the BELONG roll-out initiative.

The store estate in Spain is continually reviewed and a low average lease exit period of one year gives flexibility to move to better stores in existing locations and to open in new locations.

The first quarter has shown encouraging growth with retail GTV across the group up 4.5%. That was led by the UK (+6.6%) but Spain was also ahead (+1.7%), with trading in both geographies ahead on the back of new classic releases such as Spiderman and Red Dead Redemption 2.

In total we maintain our GTV forecast of a c 2% decline in core activities, largely mitigated by increasing momentum from BELONG. In content, we reflect continuation of the mix bias in favour of digital. However, with a strong pipeline release, the console industry has started a market fightback that we expect to continue through the first half of FY19. We are conscious of the generally soft retail market and reflect this mainly by shading margin assumptions to remove any optimism against rates actually achieved in FY18. We also increase early-stage overheads of BELONG. As a result we reduce our forecast EBITDA by 7% in FY19 and 9% in FY20. We also introduce FY21e with 7% EBITDA growth:

Our current forecast is therefore as follows:

Net cash at July 2018 (net of all financial liabilities) was £56.8m, a £14.2m increase year-on-year. The main elements were cash generated by operations of £12.1m, proceeds from the sale of Multiplay £14.9m and of the BELONG IP £3.2m, net interest and tax (£4.6m), gross capex (£10.1m) and the residual dividend payment of £1.7m. We forecast net cash above £50m for the next two years.

At July 2018 GMD had undrawn total facilities of £130m, increasing to £169m at peak. Its UK asset-backed revolving loan facility is £50m (extendable to £75m) and short-term Spanish facilities of €28m, are extendable to €44m at peak. In addition it has facilities from SDL consisting of a £20m unsecured working capital facility and a £35m unsecured capital expenditure facility expiring 31 January 2019 (with an option to extend) and 31 January 2023, respectively.

We approach valuation on two metrics: peer comparison and DCF.

There are no direct UK quoted peers. However, in the US GameStop (market cap c US$1.5bn) which has some similarities to the core business (although not to BELONG), trades on year 1 and 2 EV/EBITDA of 3.2x and 3.4x, implying a GMD valuation of 55p (previously 59p). We also consider some UK operators that serve special interest groups: Games Workshop, Goals Soccer Centres, Focusrite and Everyman Cinemas. These have de-rated somewhat since our last note in August 2018, and now trade on an average year 1 and 2 EV/EBITDA of 10.2x and 8.9x respectively against 13.9x and 13.1x then. This implies a GMD value of 96p (previously 126p). Averaging the two peer comparisons results in 75p (previously 93p).

The BELONG roll-out is central to GMD’s strategy and makes a DCF valuation especially appropriate. There is clear execution risk, which we recognise with a high 15% WACC. We model undemanding revenue growth peaking at 7.5% in FY21 before fading to a terminal 2%. We continue to assume a terminal EBITDA margin of 4.2% (FY18e: 1.3%, FY20e: 2.1%) and capex at 2% of revenue. As a result, we value the shares at 59p (previously 61p). That is c 10p sensitive to a 1% change in WACC and c 20p sensitive to a 1% change in the margin assumption.

Averaging our peer group and DCF metrics, we define a blended valuation of 67p (previously 75p), the reduction mainly resulting from the derating of peer stocks. It still gives c 140% upside to the current share price.