Game Digital — Not a game changer

Game Digital’s trading statement released on 30 June 2017, a month before year end, centred on supply issues with the Nintendo Switch console. The Switch, launched in March 2017, received industry acclaim for breaking new technical ground. Its premise is to function both as a console and a handheld device, allowing the user to transition from playing games at home to using them on the go.

Nintendo told the press that global sales of the Switch to its March year-end surpassed its own expectations, with 2.7m units shipped against a target of 2m. With demand outstripping supply, the company is stepping up manufacturing production ahead of the Christmas buying period. Its forecast for this financial year remains 10m units, although analysts expect it is targeting substantially higher numbers (source: FT 28 May 2017). This is clearly good news for Nintendo, and its share price is up 61% since the end of March. It is also likely to boost publication of related content. We think it is overwhelmingly likely that Nintendo will increase production, in part to support sales of its own major related software release Super Mario Odyssey.

In its interim results released on 29 March, GMD stated that the Switch launch had brought impetus to the market generally, and that management anticipated the overall UK market to remain positive during the rest of 2017, underpinned by the successful launch and continued consumer demand for the Nintendo Switch, as well as the planned launch of Xbox Project Scorpio (now named as Xbox One X) and a stronger slate of new titles later in the year. The retail mint market in first seven weeks of GMD’s second half (ie, broadly the months of February and March) had been up 22% in the UK and 51% in Spain. However, going forward, continuation of the positive momentum would be “highly dependent” on stock availability.

These numbers indicated that despite the supply risks there were reasonable grounds for expecting that positive progress would be retained through the second half. The reality, however, is that this has not happened. Whereas Spain has continued to trade strongly (the Spanish games market as a whole is up 19% y-o-y for GMD’s H2 to date), and the supply of the Switch has not been such an issue in Spain, supply difficulties have affected sales in the UK, where the market fundamentals are not as positive.

The Switch supply issue in the UK can therefore be summarised in four points:

The effect of this on GMD has been that not only hardware but more importantly related software sales have been lower than expected. It was always foreseen that the launch of a new console would depress sales of competitive technologies such as Xbox and PlayStation as well as Nintendo’s existing products. This situation is exacerbated if availability following the launch is delayed. In addition the launch date of Microsoft’s upcoming product, the Xbox One X (previously known as Project Scorpio), was announced on 12 June 2017 as 7 November 2017. Microsoft confirmed its technical properties in a presentation at the E3 games conference, supporting its claim that it is the most powerful console ever made, overtaking the Sony PlayStation 4 Pro, launched last year.

We understand that stock allocations of the Switch between retailers have not changed significantly, so we do not believe this situation reflects an issue in relation to GMD’s market share within the UK market.

In terms of core market sales, GfK UK market data for the first 26 weeks of the calendar year indicate that total hardware and software retail sales of the industry-leading PlayStation (PS4, PS3) and Xbox (XBO, XB360) are down as a whole c 16% year-on-year. However, this is probably a timing issue reflecting a comparatively weak first calendar half for content releases. We would expect the situation to correct in H2 with the release of several strong titles such as Destiny 2, Battlefront 2 and Call of Duty. This supports the view that calendar 2017 will be a year of two halves, and that IHS/IDG forecasts early this year suggesting core hardware and software close to flat year-on-year for calendar 2017 as a whole may yet be proved correct.

In addition to the direct effect on hardware and related software sales, there are indirect effects on other product categories. The Pre-owned category is affected in the same way as mint content and hardware sales, by customers further delaying purchases in anticipation of more attractive releases. The Accessories category is linked to hardware sales as it includes items such as controllers, headsets, plugs, connectors and other parts that are commonly sold along with new hardware.

Taking all factors together, management is now guiding for gross transaction value (GTV) growth in H2 to 5-6% (on a 52-week basis), which compares with our previous forecast assumption of 17%. As a result, EBITDA for the year is now expected to be substantially below previous expectations.

Development of new BELONG in-store gaming arenas is progressing, and the concept now trades in 12 locations, with an expectation of 20 in the full year. This is lower than our forecast assumption of 30, although we did not expect significant profit contribution in the year from these developments. This means, however, that there is a lower base of developed arenas going into FY18 than we had expected.

Clearly GMD’s change strategy embodies significant execution risk. Also, outcomes in this fast-changing market could differ from market projections, whether favourably or unfavourably:

As a result of the factors explained in the trading statements we are downgrading our FY17 GTV and revenue forecast for the whole of FY17 by c 4%. Gross profit is affected at a blended margin of 23%. However, EBITDA is highly geared to gross profit, causing a 53% impact on EBITDA for the year. The factors affecting the final months of FY17 will likely persist into particularly the first half of FY18, where we lower our revenue and EBITDA forecasts by c 3% and 29%, respectively. We assume that the company will wish to prioritise cash for growth in the period until FY20 and, as a result, we have removed dividends from the FY17 final from our forecast.

In our initiation note we addressed valuation on three metrics: peer comparison, DCF and sum of the parts.

Because of the low level of GMD’s pre-tax profit forecast in FY17 and FY18, peer comparisons do not currently give a meaningful valuation on this basis. However, the closest peer, US operator GameStop, trades on an EV/EBITDA of 3.7x for both years one and two. This implies a valuation of 46p for GMD. We also compare GMD with UK small caps serving special interest groups: Games Workshop, Goals Soccer Centres, Everyman Media Group and Focusrite. These trade on an average year one EV/EBITDA of 12x, falling to 11x in year two. That implies an average GMD value of 117p. However, based on EV/EBITDA our blended peer valuation is now 82p. We previously had peer valuations averaging 89p.

We believe DCF is an appropriate metric because it reflects the medium-term strategy as well as risks. We apply a high 15% WACC reflecting the inherent execution risk. The setbacks reflected in GMD’s trading statement do not, we believe, have an impact on the achievability or timing of this plan, and they therefore have a relatively minor effect on the valuation metric, producing a valuation of 81p, down from 91p in our initiation, on the same assumptions.

We explained at initiation that our preferred measure is to create a valuation of growth categories valuing their cash flows independently from non-growth categories. On this basis, applied consistently, we value the growth businesses at 76p and non-growth operations at 10p, for a total of 86p (previously 100p).

Averaging all three metrics, we define a blended valuation of 83p (previously 93p).