Finding The Big Winners In UK Gaming - Frontier Developments And Codemasters

14th May '20 by Jack Brumby

13 comments 5796 reads

While the rest of the economy is in lockdown, UK gaming is in rude health. The global market is forecast to grow at c9% annually for years into the future, and next gen consoles are set to be released in late 2020. Because of this positive outlook, I’ve been covering the sector in a little more detail recently.

I’ll take a break from UK gaming after this article, but the long term growth trends that underpin this market aren’t going away anytime soon.

So far, I’ve looked at Keywords here, TM17 here, and Sumo here. There are three other companies currently on my list: Frontier Developments, Codemasters, and CD Projekt. I haven’t managed to take a look at CD Projekt yet but it is by far the largest of the set and looks to have a differentiated business model - so definitely worth investigating in future.

Of the remaining two, Frontier Developments says that lockdown-related demand for games is having a positive impact on sales globally, while Codemasters has also reported strong trading. Given the continuing market volatility, strong current trading is a big plus in my view.

The wider UK gaming set continues to outperform the market year-to-date.

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As with all the video games companies I’ve encountered so far, Frontier Developments (LON:FDEV) and Codemasters Group (LON:CDM) are both high QM stocks - ie. “highly profitable and growing, but expensive”. Their market outperformance comes despite decidedly punchy trailing twelve month PE ratios for all involved.

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High relative valuations can be justified by strong growth rates and large market opportunities. Here are the 3Y revenue CAGRs for all of the companies:

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Strong market growth prospects and government tax breaks

Thematically, as a long term investor, I like the idea of having exposure to UK gaming. This sector alone is worth c£4bn - more than the UK music and TV sectors combined - and it is expanding all the time. I can see a couple of key growth drivers.

Video games’ tax relief (VGTR) was introduced in 2014 and has supported the growth of the sector. The EU commission is committed to this scheme until at least 2023. All five companies in the sector benefit from the policy. It will be a helpful…

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ACounsell

14th May '20

Perhaps when the 30% of the workforce currently on furlough (according to the media) go back to work some of the heat might go out of the gaming valuations? At the moment these people are paid c. 85% of their net salary (see my SCVR comment today on the subject) to watch Netflix or play computer games. Hardly an incentive for them to return to work and very frustrating for people still working, many from home, who may see their internet speeds suffering with all the online gaming! However, given the likelihood of mass unemployment perhaps these businesses will grow into their valuations as many people will have nothing better to do. Holding shares in these businesses could be a useful hedge or diversifier alongside Gold and Government bonds as we face economic Armageddon! An added bonus is they may pay a dividend for income unlike Gold & zero interest gilts!

Magicmerve

15th May '20

This post has certainly caught my eye. Being a gamer myself it is an area I've been looking at investing for some time, but just haven't done enough homework. I've noticed the rise in streaming content is constantly on the up and the stats on here clearly prove that the gaming sector is booming.

Codemasters looks interesting, but I have just one question........if Frontier have a licensing deal for a Formula 1 game how will this affect Codemasters? Is it an official game or some sort of collaboration with software / development?

Alan Partridge

This was my first reaction but my understanding is that they are different types of game with no crossover. Codemasters is the racing simulation specialist whereas Frontier specialises in management games. A bit like Fifa or PES versus Championship Manager. So I don't think they affect each other at all.

Jack Brumby

This is something I was trying to unpick but I couldn't quite pin it down for certain... I'm sure the answer can be pieced together from the various updates.

My understanding is that Codemasters Group (LON:CDM) has a long standing license agreement to produce F1 racing games - something that its EGO engine is uniquely equipped to do.

As Bashley says, Frontier Developments (LON:FDEV) appears to be making a different game with more of a focus on car team management. Perhaps one day these two games could end up merging into one comprehensive package but that is pure speculation on my part.

As I see it both are "official" given the licenses but the games just emphasise different aspects of F1. I wonder if anyone else can confirm this?

timarr

Obviously some of the impetus to share prices is a direct impact of having people stuck at home looking for things to do. Some of that is adult related but a lot of teenagers, particularly boys, are relying on gaming to spend time with their friends (well, they are round my way).

As with a lot of the sectors seeing a lockdown boost the question is whether it's temporary or permanent. There'll be no absolute answer to that until after the event but there is at least one of thing that suggests that the economics of the industry will be permanently improved - the current enforced closure of physical retail.

This has two effects. Firstly people who have never bought a game online before are having to do so and have suddenly found they can do easily and with virtually no effort. That's likely to have a beneficial impact on gaming volumes for a considerable time - especially if normal modes of entertainment remain closed for months.

Secondly, online sales provide a margin boost to gaming companies either by completely cutting out the distributor costs or, where the distribution is done by an intermediary like Steam, significantly reducing the incremental costs of producing the display materials (case, inserts, discs, etc). Codemasters Group (LON:CDM) specifically referenced this latter point in its recent update:

The shift to digital delivery has accelerated greatly, which has contributed to higher margins, with traditional retail and box sales impacted, exacerbated by the closure of the majority of game retailers.

The ability of the internet to shrink the distance between producer and consumer and significantly reduce the costs of distribution has been understood for 25 years. The challenge has been that human buying behaviour tends to be sticky. However, once people can be persuaded to try something and find it's easier they'll keep on doing it.

We're seeing similar trends in areas as diverse as online food shopping, home working and the use of contactless cards. The trick is trying to figure out what that means for the world post-virus but none of it looks particularly positive for traditional retail or commercial property.

cmpeckham

I'm no expert but I believe the games are really looking at different things. I found this useful in giving an idea of what the FDEV game might include:

https://www.pcgamesn.com/frontier-f1-management-games

Obvs don't take that as the real functionality, but it shows you the type of game it might be, which seems very different to the CDM game.

willhampson

Thanks for the interesting article, Jack. As a gamer, I've often been intrigued about investing in the industry but have always been a tad weary investing in the more niche smaller developers listed in the UK. While focusing on one area for gamers, e.g. strategy/management games for Frontier Developments (LON:FDEV) and racing for Codemasters Group (LON:CDM), to me it has always seemed a bit of a risk (although I take the counterpoint that it allows them to specialize in these genres). Personally, given the lofty ratings and little margin for error (e.g. a game flopping), I'd prefer to invest in a larger diversified publisher e.g. Activision ($ATVI) or Electronic Arts ($EA). They are not on a dissimilar (or lower) forward earning rating and seem safer bets to me. No position in either. Nintendo also offers decent exposure to the industry for obvious reasons and can be bought through a few brokers over here.

Hi Tim,

- Completely agree w/this. My view is that lockdown will act as a 'nudge' for entrenched trends such as the profound shift to online that is an ongoing dynamic across multiple areas of the economy.

I consider gaming, and particularly the cloud-based, digital-download, games as a service model, as part of this "mega" trend. It should make for higher margins.

My current view is that lockdown conditions will provide a short term boost that might fade (I think more likely it will add to established momentum), but either way the underlying favourable long term trends should endure - in this part of the market at least.

MrSmallCaps

Hi Jack,

I'd be interested in your view on Codemasters heavy capitalisation of Software Develpment wages and consistently lumpy/poor FCF generation. It actually looks more expensive to Team17 for instance on P/FCF basis

djack

I've enjoyed reading this series. Having grown up with agmew of the games these brands make I was keen to invest in some of these stocks.

However, I don't agree with assessing Codemasters Group (LON:CDM) based in its niche. In the end, when assessing one company against another in their games' appeal to users, it's worth considering share of time. One game will take time away from another and even with a lockdown, there's only so many we can play in a day. So I would look a game's 'stickiness' if you want to inform your buying decision on their games catalogue.

dustyie

16th May '20

the link below is to old news item concerning gaming companies on the sweden market which might interest anyone researching this sector . it

https://europeangaming.eu/portal/latest-news/2018/06/22/22246/swedish-stock-exchange-has-the-largest-number-of-online-gambling-companies/

I own the following companies listed on sweden market and nasdaq,
NetEnt AB (publ) and Evolution Gaming AB also GAN on the nasdq , there is huge growth perdicted in the gaming / casino area for the few years especially in the US.

finebone

Excellent article, Jack.

Any thoughts on mainly online gambling companies?

I know from personal experience that there has been a boom in online poker since the start of the lockdown.

Kindred Group PLC (owner of Unibet and 32Red), listed in Sweden, has recovered pretty well in the last 2 months.

Flutter has done even better, despite having a lot of betting shops, but this is probably due to a possible deal with Stars Group.

UK listed companies with (closed) betting shops and casinos etc have not done so well.

NeilS

17th May '20

Hi Jack

Thank you for a great series of articles.

My interest in Frontier Developments (LON:FDEV) became an investment last year when it emerged that Tencent had bought a stake (and I seem to recollect may also have board representation?).

The opportunity to distribute considerable volumes into China via Tencent may well be what is helping them to sign up exciting new IP such as Games Workshop as this will also help Games Workshop (LON:GAW) to build brand awareness in the Chinese market. A virtuous circle in the making. Quite a powerful forward looking strategic opportunity which looking forward 5-6 years I feel should payoff considerably.

All the best

Neil

Finding the big winners in UK gaming - Frontier Developments and Codemasters

Strong market growth prospects and government tax breaks

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Jack Brumby

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