Stock Pitch - Codemasters (LON:CDM)

Video game developer and publisher Codemasters was pitched to the Stockopedia Investment Club on 7th April 2020. With a lockdown in place and the economy in turmoil, one of the first sectors to see a boost from the unusual conditions was the video games industry. The shares were bought at 270.40p and they currently trade at 400.00p. NB - CDM is from our archive of several pitches made earlier in the year. In future, stock pitches will be published immediately after meetings.

TLDR;

Codemasters Group Holdings plc: a mid-cap growth stock offering exposure to the burgeoning video gaming and e-sports industries.

• Bull Points: Strong niche position in "racing" games, strong brand connections, multiple growth levers, becoming more profitable, Covid beneficiary.
• Bear Points: Potentially over-reliant on the success of a few games, competitive market, shares could be expensive, CEO and CFO both sold shares in January 2020.

Profile

• About the Stock: Codemasters is AIM listed and classified in the Technology sector. It develops and publishes video games that are either bought by consumers from retail outlets or digitally via games platforms. It currently trades at 400.00p per share and has an EMS of 3k.
• Opportunity Type: This is a Mid Cap with a £629.5 million market cap and is classified as Adventurous on the RiskRatings spectrum. The StockRank is 74, with quality and momentum being the strongest factors - qualifying it as a High Flyer.

Business & Model

• Company History: Thirty year track record as one of Britain's best known video games developers, specialising in high quality racing games. Founded in 1986, based in Warwickshire and floated on AIM in June 2018.
  
• It manages four main games franchises, including ‘DiRT™, GRID™, Project CARS and F1®. Earlier this year it won the right to develop and publish games and e-sports tournaments under the FIA World Rally Championship brand (coming in 2023). It also has a growing back catalogue of ~15 profitable titles plus many others. It is growing well organically but has made acquisitions and intends to make more.
  
• Business Model: Codemasters owns the IP to DiRT, GRID and Project CARS and licences the IP to F1. It has teams of developers introducing new versions of the games, often annually. Distribution to traditional retailers is handled through a third party, Koch Media. But distribution through the increasingly important online games platforms - including Microsoft (Xbox), Sony (PlayStation), Apple, Google (Stadia) and Amazon (Luna) - is handled by Codemasters itself. In addition, Codemasters plans and executes all its own marketing in-house.

Market & Competition

• Market: Global games market is estimated to be worth ~$137 billion and anticipated to grow by 10% per year in coming years (research by Newzoo). China is becoming an increasingly important new market and the industry is being driven by new developments in streaming and mobile.
  • Xbox and Playstation are launching new gaming systems (Xbox Two and Playstation 5) this year, which usually boosts games sales.
    
• According to a report by Newzoo, global esports revenues are projected to break the $1 billion barrier ($1.1 billion) for the first time in 2020, up 15.7% from the previous year (Codemasters annual report). By 2023 the figure is expected to rise to $1.55 billion.
  
• Competitors: There are other games/developers in the racing games space (such as Forza Horizon and Gran Turismo). But there's no doubt that Codemasters benefits from specialising, and growing a stronger presence, in the racing genre.
  
• More of a risk is the potential to lose the F1 licence (although it was recently extended from 2021 to 2025 with an option over the 2026 and 2027 seasons) or for F1 to become less popular. It's also at risk of poorly received new titles, which require significant upfront investment.

Strategy & Competitive Advantage

• Strategy:

  • In the past Codemasters made games across a number of different genres but has opted in recent years to specialise (in racing games). It now aims to have products that appeal to anyone from casual game-players right through to e-sports professionals.
  • Digital sales are an increasingly important factor in the industry - known as "games as a service" (GaaS). Digital sales represented 67.7% of total revenue in 2020 (total revenue was £76 million), up from 59.2% in 2019.
  • Looking closely at mobile offerings. The company has a partnership with Chinese developer Netease for mobile gaming, expected 2022.
  • Esports - Already growing before Covid, esports has been a boost for Codemasters. The company filled the postponed F1 calendar with the F1 Esports Virtual Grand Prix, which got 30 million views.
  • The company is aiming to build out its titles (while continuing to profit from its back catalogue), and dominate the racing game niche.
  • In 2019 it acquired the racing game developers, Slightly Mad Studios, which added the Project CARS and Fast & Furious game franchises. The company has seen strong organic growth in 2020 but further acquisitions - adding either IP or studio skills - are possible.
  • The main priority is to grow its audience and increase average revenue per user. This is happening through the more profitable digital downloads and the introduction of "add-ons" and in-game purchases.
    
    

• Competitive advantage

  • Strong positioning and expertise in the racing game niche. Thirty years of experience in this area meaning that it has developed proprietary gaming engines that are optimised for the graphically demanding racing genre.
  • Strong IP and licences IP with F1.
  • By fully focusing on building its brand in racing games, Codemasters says it's aiming to be the "go to racing channel for both gamers and licensors hence raising competitive barriers to entry."
  • Constantly increasing size of its back catalogue gives it a growing source of high margin tail-end sales. It also improves its marketing abilities (options to offer free games as a teaser to buy new titles).

Financials & Ownership

• Codemasters recently turned profitable - Sales have been growing consistently over the past five years and in 2019 - the year it floated - it turned profitable. In 2020 (results were announced in June 2020) it posted sales of £76 million and a net profit of £11.6 million. Forecasts indicate that will accelerate in the current 2021 financial year. 2020 margins were strong, at 20.9%, with ROCE of 12% and ROE of 17% all encouraging quality clues.
  
  

  
  • Balance sheet strength - Cash is solid at £25.6m. Capex is stable and the business is now cashflow positive. It's debt free. The F-Score is a mediocre 5/9.
  • Share dilution - It raised £20 million of equity last year to fund the Slightly Mad Studios acquisition. With more acquisitions potentially on the way, there's a risk of more dilution, although the cash position has improved a lot, so it appears to have options.
  • Ownership structure - Slater Investments in the largest institutional holder with a 9.91% stake, followed by Soros Fund Management with a 9.5% stake. Overall, 48.5% of the shares are held by the top holders.
    • When it floated in 2019, 50% of Codemasters was owned by Reliance Big Entertainment. That holder has now exited. CEO Frank Sagnier reportedly made £10.1million at IPO.
    • In January 2020, Sagnier sold £1.2m of his holding, leaving him with a 2.1% stake. CTO Rashid Varachia sold £0.52m leaving him with 1%.

Valuation

Relative Valuation

• Codemasters has a ValueRank of 12/100 - down from 23 at the start of 2020 and down from 40 when it floated in 2018. This suggests it has always had a slightly premium rating but is currently as expensive as it ever has been.
  

• The current P/E ratio of 46.5x falls to a forecast P/E of 22x, which is more reasonable. That's based on the EPS more than doubling from 8.9 in 2020 to a forecast 18.7 in 2021. The question is whether the company can continue to meet and preferably beat forecasts with its growth ambitions.
  
• A forward PEG ratio of 1.0 is slightly shy of Jim Slater's preference for <0.75, but this still falls into the "Zulu" stock category that would have appealed to him - and explains why Mark Slater has a 9.9% stake.

Intrinsic Valuation

• Liberum (the nomad and joint broker with Jeffries) research note on the H1 2021 results on 7 October set a target price of 435.0p (against the publication price of 359.0p). It says CDM has closed its discount to the wider UK gaming sector over the last year but still trades on 20x CY21 EPS, c.30% below UK peers.

Recent Trading

• In its half-year 2021 trading update on 7 October 2020, the company said:
  • Trading was strong throughout H1
  • H1 revenue would be ~£80.5 million (up from £39.8 million in H1 2020)
  • Digital sales had risen to ~73% of revenue (up fro 61.7% in H1 2020)
  • Cash at H1 was £49.8 million (up from £24.6 million in H1 2020)
  • F1 2020 game had boosted sales

Trends & Catalysts

Are there any catalysts that could drive a rerating in the short or medium term?

• Codemasters' focus on racing games gives it a very strong position in a highly popular gaming genre. Short term, with new Xbox and Playstation platforms on the way, the company looks well placed to benefit over Black Friday, Christmas and New Year.
• Longer term, the company appears to be benefitting from growth in digital distribution, GaaS and in-game purchases and post-sale add-ons. This should see the company increase revenue per user and lead to higher margins.
• Sales in the US have been stronger than expected. But there is also strong growth in China. New markets should be a boost for the company's customer base.
• Codemaster released its full year results in June. A H1 2021 update was published in early October. The official H1 figures for the six months to September 30 are expected on November 23.

What are the biggest risks?

• Valuation - The shares currently look expensive as momentum in the stock is building. So far, the company has over-achieved on revenue and sales growth, but any mis-steps over the next 18 months could affect the price. While the company has benefitted from Covid circumstances, high momentum stocks could be sold-off if the market falls.
• Execution - Codemasters has a solid base of IP and games titles, but constant development demands upfront investment and failure here could be damaging. The F1 licence has been extended, and fortunately the F1 continues, but any disruption there could affect games sales.
• M&A - Codemasters says it's on the look out for acquisitions, although strong organic growth means that it can be picky. Acquisitions come with deal risk, and while Slightly Mad Studios is reported to be trading in line, there are no guarantees that acquisitions will always work.
• Acquisition of intangibles and lack of resulting free cash flow - on a technical point, there is an 'unknown' concerning the consistent acquisition of intangibles (shown below on the cashflow statements) and the resultant impact on cash flow. Is Codemasters running to stand still?

Sentiment

• Liberum's most recent note stated: "Importantly, today’s update highlights the potential of the F1 franchise (the company has grown it to over £50m of annual revenue a couple of years faster than we expected) and the opportunity to develop and expand other franchises. We reiterate our BUY recommendation and Target Price of 435p."

• Solid community support suggests that private investors are encouraged by the story
  

  

• Director dealings - CEO, Frank Sagnier and CTO Rashid Varachia sold considerable holdings in January 2020, leaving them with stakes of 2.1% and 1% respectively. Arguably they are still meaningful stakes and the timing of those sales wasn't brilliant (given the subsequent price rise), suggesting that there may have been personal reasons behind the sales.

What would the person selling to us be thinking and who are they?

• Profit takers looking to shift out of small- to mid-cap tech-oriented stocks, perhaps selling on the price looking "full"
• Those who looking to de-risk portfolios from more speculative momentum shares ahead of any market disruption caused by Covid

The verdict

Overall, the Stockopedia Investment Club were positive on what they saw and a purchase was made the following day.