Game Digital — Sales recovery sees strategy on track

GMD has reported results in line with our expectations, after a decisive trading recovery in H2:

The second-half pick-up was largely caused by the expected supply improvement to the new Nintendo Switch console which, following launch in March, had suffered shortages in H1 as a result of significant demand far outstripping demand.

The major takeaways from this analysis are:

This therefore indicates a combination of positive developments which, as well as fulfilling the expected resolution of the Switch supply situation, shows underlying trends moving in GMD’s direction.

The 2.4% overall decline in GTV translates to a 3.6% decline in revenue, the difference attributable to the increase in digital content, which attracts a lower revenue share.

Gross profit, down 60bp overall, combined several factors, all of which are a function of market developments that are overall positive for GMD:

The reported decline of 0.6 percentage points was net of a 1.9 point improvement in hardware on the swing to new models, and a currency benefit worth around one percentage point. Elsewhere, lower margins were associated with higher mix of new product types. In content they related to the increased digital volumes. In pre-owned categories they related to a higher mix of new format (Xbox One and PlayStation 4) related products which, while reflecting the increased technical sophistication of the market, attract lower margins. In Accessories & Other they were affected by the advent of virtual reality devices, which are of course likely to be a significant top-line opportunity in the gaming space over time.

Operating costs, before depreciation and amortisation, adjusting and exceptional items, and on a 52-week basis, rose 2.8% from £191.8m to £197.1m. Around £11m, or 5% of costs, were saved by the UK programme, comprising store efficiencies, rent and rates, distribution efficiencies, marketing and overheads, but against that £3.7m of headwinds arose from wage inflation, investment in multi-channel and customer service improvements, and first time office leaseback costs following the sale in October 2016. Retail costs in Spain, though only up 4% in currency terms against GTV growth of 6.9%, were up 18.2% or £8.6m in sterling terms. A further increase of £4m resulted from the rapid expansion of the Events, Esports & Digital operation, including the first-time inclusion of BELONG and the scaling up of Multiplay operations, both participation and digital.

While the difference between the first and second half result is encouraging, underlying market trends support the business strategy. Among the underlying positive trends becoming apparent are:

The release of Switch is very promising with, as expected, experience after 36 weeks placing it midway between the all-time record-holder the Wii and the less successful Wii U. Extended to three years this indicates upgraded projected sales volumes in the UK and Spain of 3-4m units (source IDG forecasts quoted by GMD), which compares with 1.7m units of combined Xbox and PlayStation sales in FY17.

In addition, the software tie ratio of 3.0 times is in line with the Wii (3.1 times), showing good prospects for content sales into the future.

Against these, negative trends emerging are:

In our initiation The Long Game, published in April 2017, we argued that GMD is engaged in a strategy to transform the company from its former role as a purveyor of hardware and content product, to an organisation that is engaged with its interest group and with a spread of offerings that includes experiential as well as physical product. The company is delivering on its strategy with a range of actions falling under four headings:

BELONG is now in 18 stores and management has accumulated significant experience. We understand that the best returns are being achieved in busy high street or city centre locations, which is likely to focus current development priorities for its target of 35 developments in FY18.
The Insomnia festival has been further developed in the year and attracts an audience of up to 155,000. Between this level and BELONG, there exists a network that management has developed from the non-digital business of its Multiplay acquisition of eSports events across the UK and in Spain. Total events sales grew 48% in FY17 to £7.1m.

Although the digital B2B operation of Multiplay has been placed under strategic review, this is from a position of strength in which sales grew by 114% y-o-y to £4.5m.

We note above that the company achieved UK cost savings of £11m. These consist of the annualisation of FY16 savings amounting to £6.2m, and £4.9m of additional savings in FY17. In addition, total savings of £8.3m are targeted for FY18 across property, payroll and other areas.

We make no material changes to our forecast GTV and revenue. However, we reduce FY18 forecast EBITDA by £1.1m to £12.3m, mainly as a result of rolling forward gross margin mix effects. Resulting EBITDA of £12.3m still represents 54% growth on FY17.

Net cash at July 2017 was £42.6m, a £4.1m increase year-on-year. The main elements were cash generated by operations of £10.0m, net interest and tax (£2.3m), capex (£11.6m) and proceeds from the sale and leaseback of the head office of £13.3m.

At July 2017 GMD had undrawn total facilities of c £77m, with a UK asset-backed revolving loan facility of £50m (with peak extension to £75m) and short-term Spanish facilities of €30.0 million. The latter have been extended to €40.6m to cover peak trading. As a result, the company’s total facilities currently amount to c £86m, of which c £75m is undrawn.

We address valuation on three metrics: peer comparison, DCF and sum-of-the-parts.

Since our pre-tax profit forecasts for GMD are low for FY18 and FY19, peer comparisons on P/E ratios do not currently give a meaningful valuation. We therefore compare with peers on an EV/EBITDA basis. The only close peer in the sense of being a gaming equipment retailer is the US operator GameStop. GameStop trades on an EV/EBITDA of 3.2x for both years one and two, compared with GMD’s valuation of 2.1x falling to 1.7x. While low compared with other retailers, this in itself would imply a valuation of 50p for GMD. We also compare GMD with UK small-cap companies serving special interest groups: Games Workshop, Goals Soccer Centres, Everyman Media Group and Focusrite. These trade on an average year one EV/EBITDA of 13.7x, falling to 12.1x in year two. That implies an average GMD value of 125p. Taking an average between these two levels, our peer valuation is 88p (previously 82p).

We believe DCF is an appropriate metric because it reflects the medium-term strategy as well as risks. We take a cautious approach in extending our forecast to 10 years, stepping down assumed GTV growth from 16% in FY20 to 10% in FY21 and 5% thereafter, fading in the last three years to 2% in the terminal period (this represents a later phasing of growth, which we previously showed as 26% in FY20 followed by 4% in FY21 and thereafter, again fading to a terminal 2%). We apply a high 15% WACC reflecting inherent execution risks. This results in a valuation of 72p (previously 81p).

We explained at initiation that our preferred measure is to create a valuation of growth categories valuing their cash flows separately from non-growth categories. On this basis, applied consistently, we value the growth businesses at 70p and non-growth operations at 10p, a total of 80p (previously 86p).

Averaging all three metrics, we define a blended valuation of 80p (previously 83p).