Game Digital — The long game

Game Digital (GMD) is a vendor of video game experiences, trading in the UK and Spain. Its product range includes software, hardware, events and playing opportunities. Currently it is the market leader with a 29% share (among retailers, including Amazon) of games hardware and software in the UK and 39% in Spain. Its strategy, while preserving that leadership, is to maintain and develop relevance to its interest group. As a retailer, GMD has some advantage as its product area is experiential, so that service, trial and participation are integral. Arguably it is a more direct path for GMD to adapt to the connected world than for retailers rooted in old-world product transactions. GMD’s multichannel strategy aims to reach customers through terrestrial stores, the website, the app, esports (online sports contests), gaming events, media and community activity.

The first half to January 2017 saw a 30% reduction in EBITDA to £23.3m. While gross transaction value (GTV) only reduced by 0.5% (excluding lower-margin hardware), unfavourable mix factors at gross profit level (down 5.6%), together with cost increases mainly on investment in growth, caused the rest of the decline. Pre-tax profit was down 39% and the dividend reduced from 1.67p to 1p. The results suggest that for the moment the company is still over-dependent on the market cycle.

Although cautious on any H2 boost from Switch, we forecast pre-tax profit stabilising in single digits for FY17-19, as growth in cycle-independent streams counters further cyclical weakness, and growing strongly in FY20 as they reach 77% of EBITDA and the cycle also recovers. Positive cash generation throughout provides significant protection. Bank facilities are £80m (c £125m at peak).

We value the company on three measures:

The three metrics combine to a blended valuation of 93p. This implies an FY17e P/E multiple of 34x, which is unlikely to be seen soon: the shares represent an opportunity on a medium-term view.

Clearly GMD’s change strategy embodies significant execution risk, but the main commercial risks to valuation that we see relate to its dynamic markets. Reality may differ from forecasts that assume the next market upturn in 2019. Advances in digital technology could skew outcomes, especially if the market moves further to digitally delivered content. Product-led changes such as reaction to console releases, virtual reality or category-killer products may change behaviour, while GMD’s creation of new markets such as events and esports could have a greater or lesser effect on results than we have assumed. In addition, GMD’s high overhead structure means earnings are highly geared to top-line changes, though potential estate reductions could change that.

Game Digital (GMD) is a vendor of video game experiences. Its product range includes software, hardware, events and playing opportunities. It is the UK and Spanish market leader with a 29% retail share in the UK and 39% in Spain. Its strategy is to maintain this leadership, develop services and build new markets.

GMD was admitted to the premium segment of the LSE in June 2014 at 200p, after the predecessor business, Game Group, went into administration in 2012. Game Group had a focus on product retailing, with c 870 stores. GMD now has 581. The estate reductions were mainly in the UK, which has halved to 311. In the more stable Spanish market the estate of 270 is little changed since the addition of 44 Gamestop stores in 2014.

The prospectus highlighted certain key strengths of the reformed business. It is leader of an increasingly complex market, with a differentiated customer proposition; it has valuable customer insight and is a key partner for suppliers, with a flexible cost structure and capital-light balance sheet.

We examine below GMD’s current activities, distinguishing between those that tie it to the gaming cycle and those that develop independence from the cycle.

Console content: GMD retails a wide range of games content for consoles and PCs, including both physical boxed software and digital content – see www.game.co.uk. It has a c 33% share of the UK and c 45% of the Spanish retail market, worth c £0.8bn and €0.3bn, respectively. Through its close relationships with suppliers GMD is able to negotiate exclusive editions of many standard games, which include additional features of value to gamers, such as additional action sequences or in-game items, for instance vehicles and weapons.

We expect market share to reduce slightly in the next two years as more casual consumers enter the market during the latter stages of the cycle. This should reverse in FY20. While the total mix of physical to digital games sales has fallen from 78% to c 40% in the UK, we expect it to stabilise at around this level due to resistance to digital caused mainly by long download times and the inability to trade in used games. For example, physical games have resale value, typically £20 against a new price of £49. However, digital is lower margin for GMD at c 15-20% of GTV against a c 25-30% gross margin on physical games.

Hardware: Hardware is a natural product market for GMD because its high price and sophistication means that trial and service have value for customers. The total UK gaming hardware market is c £0.5bn, of which some 60% is bricks and mortar, and GMD’s share is c 30% (it is comparable in Spain). As described on page 5, it is console hardware that creates the volatility of the cycle. Exhibit 3 shows that hardware margins are low: between 3% and 7% depending on the age of the release. However, contact with hardware customers is key to GMD’s penetration of the gaming market generally. Here the active interest, availability and training of store staff are clear differentiators against competition.

Preowned products: Preowned products is a significant area, ranking second in gross profit terms and c 30% of the total. The category is weighted to software, and leverages GMD’s close relationship with gamers, for example making use of the mobile app to scan and trade in software. However, other than Gametronics (below) it is not a growth area for GMD, tending to track the new software market.

Accessories and Other: Accessories and Other (A&O) is mainly controllers, headsets and plugs, connectors and other parts collectively known as gameware. A small subset is Toys-To-Life, a set of model characters integrated into games by Activision. Growth in the category reflects the developing range and sophistication of games. It follows a smoother path than hardware or software, driven by underlying activity rather than releases. A&O includes virtual reality, currently a hot area, with sophisticated headsets in the £350-800 price range as well as mobile-driven versions retailing for as little as £30 (average spend is c £270). The future profile of VR is uncertain but the opportunity could be large.

Gametronics: Global mobile gaming was expected to be 37% of the total gaming market in 2016, growing at 16% (source: gamesindustry.biz quoting Newzoo). Gametronics represents pre-owned mobile and tablet hardware suitable for gaming. GTV grew c 60% in FY16 and growth is expected to continue as GMD represents a significant marketplace with strong supply relationships.

Esports and events: The global esports market is US$0.7bn, growing at a 29% CAGR to 2020 (source: GMD). It is a significant strategic area for GMD (see page 7). To date contribution is small and mainly from acquired businesses: Multiplay (March 2015) and SocialNat (February 2016). GMD’s events sales have grown by a 78% CAGR over the last three years. GMD is also developing its BELONG arena format, with nine trading so far.

Digital Services: With Multiplay GMD also acquired a game server hosting business, providing B2B solutions for games developers and publishers. Typically publishers have limited server capacity. In order to avoid server failure, the publisher may contract with Multiplay to provide capacity through a combination of firm purchase and a contingency element triggered instantaneously by demand. The operation is not currently significant to results, although contract signings could change that. The company also acquired Ads Reality, an augmented reality business, in May 2016.

On GMD’s definitions, current GTV is weighted 70:30 to core against growth activities. Growth activities as a whole earn a higher gross margin, though not if hardware is excluded from core.

FY16 does not materially include esports, events and digital operations, which on our projections should add c 4% of GTV to growth categories by FY20, raising their gross margin by c 300bps. At EBITDA level, we calculate that non-cyclical growth categories contribute over 50% of EBITDA (see page 8), and the proportion is set to grow as esports, events and digital activities develop.

We now examine GMD’s place in the existing video games market and then its opportunities in new markets, which are fast developing in a number of areas.

The core games market defines a cycle that is predictable in its volatility.

Console releases from Microsoft and Sony drive demand that has peaked every six years since 2000. Troughs occur every six to eight years in anticipation of releases. The next major event comes in 2019 with the release of PlayStation 5. In the short term, Xbox Project Scorpio, due autumn 2017, is not currently expected to have a major impact. However, Microsoft’s apparent move to shorter release intervals could itself signal the beginning of structural changes to the traditional six-year market cycle, emulating the mobile and PC markets.

The content market responds to hardware releases with a build-up of activity but is a less volatile, while larger, market and therefore provides some smoothing.

The Spanish market, responsible for c 28% of GMD’s revenue, is more stable, although like the UK it has become more weighted to digital content recently.

With the Wii, Nintendo showed an ability to further disrupt the already irregular market. In 2008 the Wii drove c £1bn of UK sales, bringing a new class of casual gamer to the market. However, its success was not replicated by the Wii U in 2012 (Exhibit 8).

Early sales of the new model, the Switch, launched in March 2017, while below the Wii, have materially surpassed the Wii U. Overperformance here could help GMD over the next years.

GMD has an innately strong market to the extent that its product is both technological and socially driven. Its specialist product knowledge and involvement connect it to the end customer. Its task is to maintain and develop relevance to the interest group. As a retailer, GMD has the advantage of an experiential product where service, trial and participation are integral. Arguably it is a more direct path for GMD to adapt to the connected world than for retailers rooted in old-world product-only transactions.

The stated strategy puts the customer experience first. The main elements are to:

GMD’s approach to retail is to exploit all channels in which it can interact with customers: terrestrial stores; website; the mobile app, events and esports; and media content. The multichannel approach is to comprehensively address customers’ needs based on a fuller relationship. The average multichannel customer spends £394 pa compared with £157 for individual customers.

Terrestrial stores: The multichannel strategy calls for stores to better engage with their annual 84 million visitors, rather than being limited to product transactions. Footfall is holding at c 1.5m per week over the last five years. But GMD aims to transform its estate. It is trialling designs for different store sizes, aimed at optimising customer experience. Where possible the BELONG concept (see below) is included. With 232 UK lease events in the next three years, GMD has significant leverage with landlords to facilitate desired changes, and could equally exit unsuitable locations, which, on the example of 2012, would be unlikely to affect market share, while reducing heavy operational leverage. On 22 leases renewed in FY16, average rent was cut by 23%, implying c £5m of potential on the £23m UK rent roll. The physical estate could reduce significantly without loss of share, as happened in 2012, and reducing cost leverage.

The website: Traffic is significant with 121 million visitors in FY16, 54 million of them from mobile devices. GTV is around 17% of total, growing modestly over the last three years, though fluctuating around game and hardware releases and retail events such as Black Friday. The site provides a shop window and order site for the full product range. Customer accounts are used to order products, while providing customer data. Additionally, the Reward Card (19m holders, 4.5m actives) accumulates loyalty points based on transactions. The site also provides links to events (see below). Free delivery is standard, with a range of options including next day and weekend delivery, and click and collect. The UK site was relaunched in October, with an increase in conversion from 1.6% to 1.7% over the next three months, indicating progress but suggesting there is more to do.

The GAME mobile app: The app has 1.5 million registered users. To join, a customer has to create a relationship with the company via the account and Reward structure. In addition, the app provides a simple way to trade in used products, which can be scanned using a mobile device. Mobile sales account for 47% of online sales (FY15: 43%).

Esports and events: Events activity is fast growing, with FY17 revenue forecast to double to £10m. The main formats are:

In addition, GMD will be launching an online platform imminently that will allow customers to view and participate in gaming events online.

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:

Results for FY16 (on a 52-week basis) showed a 35% decline in EBITDA to £27.2m. Pre-tax profit was down 39% to £16.9m and the dividend was reduced from 1.67p to 1p. This was predominantly the effect of a 3.3% decline in content GTV, which represents 44% of GTV at a c 30% gross margin. Hardware sales reduced by 22%, but as these were at a margin of only 3%, the profit effect of that was muted. Both factors reflected exposure to the cycle: GMD’s UK core retail GTV decline of 11% was actually favourable compared with the market, down 12%. Spain had a positive year with EBITDA improving by 7% to £11m, affected only slightly by foreign exchange rates in the year to July 2016.

In January 2016 a comprehensive UK action plan was implemented to respond rapidly to the change in market dynamics. Actions included:

The first half to January 2017 saw a 30% reduction in EBITDA to £23.3m. Content GTV was weaker by 1.9%, and pre-owned GTV dropped 8.7% on a net reduction in older formats, while A&O increased 15.4%. Together these caused a 0.5% reduction in GTV (excluding lower-margin hardware). However, gross profit fell by 5.6%, mainly on the mix favouring newer formats in preowned, and VR in A&O, both at lower margin.

To capture the performance implications of the cycle as well as development of cycle-free income streams, we model projections of both elements from FY16 to FY20e.

In this period, we expect GMD to grow its independent streams, comprising events, esports, digital activities, accessories, and Gametronics, from 56% to 77% of EBITDA (forecast EBITDA margin averages 7.7% against 0.7% for cyclical streams). This should give GMD significantly greater control over its market. We expect EBITDA of independent growth markets to weaken in FY17 mainly on initial costs of esports, events and digital, and then expand through to FY20. We have been cautious in not anticipating a specific uplift for Switch in H217 beyond that implied by previous market forecasts, despite early indications of strength, since GMD’s performance here will depend crucially on stock availability.

Content: In response to the market cycle (Exhibit 5), we expect GTV and gross profit to decline further in FY17-19 before recovering in FY20. We expect preowned products to be more stable as growth in Gametronics counteracts declines in content. A&O, which follows a more benign growth path, should also benefit from the esports, events and digital operations, which we forecast to grow rapidly from a low base. Hardware is low margin, but gross profit should be boosted in FY17 and FY20 by a mix bias to higher-margin new products.

As a result our forecast for gross profit contribution is essentially flat for FY17-19. The company moves into significant profitability in FY20 as a result of growth in independent streams (Exhibit 9) combining with cyclical recovery in the core market driven by the major hardware releases in calendar 2019. Importantly, that independence should mean future profitability becomes more sustainable.

It is an important feature of our forecast that while profitability plateaus over the next three years, cash generation remains significant, preserving and further strengthening an already strong balance sheet. GMD started FY17 with net cash of £38.5m; we forecast an increase to £49.4m by July 2017. FY17 EBITDA conversion should improve from 22% in FY16, when there were significant increases in working capital, to 91%. The resulting operating cash flow of £16m is boosted by £13m of office sale and leaseback proceeds, and the total of £29m is spent on capex (£13m), dividends (£5m), and interest and tax (£1m), to leave a net inflow of £10.9m. We forecast small increases in the net cash balance over the period to FY19, and a boost from the trading upturn in FY20 to £62m. Additionally GMD has significant debt facilities of c £80m (£75m in the UK and €35m in Spain) rising to c £125m at peak periods.

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

The only industry peer is US operator Gamestop, whose model resembles the predecessor Game Group rather than GMD. It trades on year one and two P/E multiples of 6.7x and 6.5x, and EV/EBITDA of 3.3x and 3.2x, implying GMD values of 18p and 58p, respectively. Also appropriate (as they serve special interest groups) are UK small-caps Games Workshop, Goals Soccer Centres, Everyman Media Group and Focusrite. These trade on an average year one P/E of 19.2x, falling to 15.5x in year two, and EV/EBITDA of 10.0x and 8.8x. That implies GMD values of 48p and 124p, respectively.

Short-term multiples are not good at valuing the medium-term transition that is really the basis for investing in GMD. However, we would attach more weight to EV/EBITDA valuations than the P/E measure. With the cycle weighing on the top line, and costs burdened by investment for change, earnings after depreciation are abnormally low. Averaging the EV/EBITDA valuations above would suggest 91p. Even taking the ultra-bearish approach of excluding cash, they would indicate 68p.

DCF is an appropriate metric because it does take account of medium-term strategy, albeit this is subject to risk across a number of years. In view of that, we apply a high 15% WACC to the future streams. To represent the cycle, we assume the next three years’ revenue growth beyond our 2020 forecast is the same as the average for the previous five (4.7%) before fading to a terminal 2% over the final three years. We assume no change in the 2020 EBITDA margin, and we conservatively reflect capex at 2% of revenue. On this basis we value the shares at 88p. That is c 10p sensitive to a 1% change in WACC and c 20p sensitive to a 1% change in the margin assumption.

Since GMD is on a path to realise a business independent of the zero-sum-gain cycle, our preferred measure is to create a valuation of each element. We define the growth element as in Exhibit 9 above. Below forecast gross profit level, we model specific operating costs in esports, events and digital, and BELONG operating costs. We then allocate operating costs pro-rata to revenue, which is slightly unfair to the growth businesses, which therefore pick up a higher share.

For non-growth operations, we reproduce the cycle by averaging the last five years’ EBITDA of core operations, and, after capex and tax, value it as a perpetuity assuming 2% growth, at 13p per share. In the case of growth businesses, we conservatively fade revenue growth from its 2020 rate of 15.5% to terminal growth of 2%, producing a DCF valuation of 87p. The sum of the two is 100p.

Averaging all three metrics, we define a blended valuation of 93p.