Description

Akatsuki is very cheap on the numbers, with a large pile of cash.  Unlike many other small cap Japanese companies sharing those two characteristics, Akatsuki has four more we like.  1) We have met with them, they are not unfriendly to investors at all; 2) It is a good business with high return on capital; 3) its core business is unimpacted by corona virus, possibly even benefiting; 4) If the crowd decides they want to like this one for whatever reason, it is not an industry where you can only sell to other value investors.

Akatsuki is a mobile video game developer in Japan with seven existing titles. Their biggest success has been Dragon Ball Z Dokkan Battle (“Dragon Ball Z”), a game “co-developed” with the IP owner Bandai Namco and launched in January 2015. It continues to grow and it is still the largest single contributor of revenue. The challenge for “one hit wonder” companies is to have subsequent successes that allow for sustained profitability. Otherwise, even <3x EV/EBIT might not be cheap enough. Predicting success is difficult, but after meeting with management in Japan last year, we came away better understanding how their process and experience helps improve their batting average.

Upstairs from our meeting on the corporate floor with the strategy officer and head of development is what they call the studio, where creative and engineering teams work on games. Sometimes they license IP and other times they develop properties internally. Either way, they do all the game development themselves. Their success creating the game makes them a partner of choice for IP owners. It’s a small world, and with successes like Dragon Ball Z, they get a lot of incoming calls. One co-founder is a programmer and the other brings creative idea generation. Ideas funnel from planning to development and then only about two titles get released each year. Beta tests and experience in the market help the company determine which projects have the highest probability for success. The company’s goal is to create a portfolio of games, especially internally developed intellectual property, and leverage them for international expansion (expanding the number of users) and ultimately for different media (expanding the economic zone) such as film. Today, about 30-40% of Dragon Ball Z is non-Japan, so they have experience releasing titles for other markets. China is not one of them. Tencent is the gatekeeper there, and Japanese game have not succeeded there.

In December 2018, they released Romancing Saga Re:Universe (“Romancing Saga”), which had 10MM downloads in its first month, far exceeding the initial performance of Dragon Ball Z, which didn’t have a 5MM download month until one year from launch. While the company does not disclose revenue by game title, they said the 22.5% revenue growth in the December quarter (one year after launch) was driven by the new game. In the FY20 (ended March) earnings release, the company called Romancing Saga its new profit pillar. Not all games will have the same initial success. In September 2019, they launched a new music game, Uni’s On Air (“Uni”), which achieved 7^th place ranking and achieving a mere 3MM downloads after about three months. There are at least three titles in development (one for 2020, two for 2021) and several in the planning stages. They average about two releases per year.

Mobile games are typically distributed on platforms such as Apple’s App Store and Google Play, which take about 30%. While these platforms have global reach, releases occur country by country. Games are downloaded for free or upon purchase, and they usually have in-app purchase features to generate revenue. Games can be internally developed (proprietary) or licensed/co-developed with some revenue share. Revenue share arrangements with the IP owner/co-developer vary by title. With a successful game, there is a ramp up period and then a long tail as updates are available for download (unlike console games) and maintain continued interest in games for years.

The company also has a segment called LX (live experience), in which they seek to create entertainment properties in the physical (vs digital) world. They built Asobuild (opened in March 2019), a Dave & Buster’s type of multi-level facility with things like dining, sports courts, kids play areas, etc. The lease the real estate, but spent the capex to build it out. The LX segment is currently not a large revenue generator, and loses money on the EBIT line.

If the dependence on a big hit (Dragon Ball Z) was the primary risk, then the second large risk in our view was capital allocation around this LX concept. The company is traditionally capital light and has had a 50%+ ROIC. The ROIC for a successful game is nearly infinite. The physical buildout plan for LX and its negative EBIT is clearly dilutive to corporate ROIC. In other words, they are taking high returns from one business and reallocating the capital to money losing businesses. The fact is, Japanese companies aren’t known for shareholder friendly capital allocation decisions.

However, we learned from our visit with them that they do think about investment, reinvestment and returns more than we initially thought. They agreed with us that both the “one hit wonder” success of Dragon Ball Z and the doubts around the LX concept were the reasons for the low market valuation. Management also said numerous times that as part of their culture, they do not like to risk large amounts of money. New games are not huge bets, and when thinking about the future, e.g., movies or television, they said it would not be them producing the film, but probably the IP partner.

In the FY20 (March) earnings release, two important things have changed that signal a material shift and refocus on the core gaming business and a retreat from investing heavily in the more capital intensive and unprofitable live entertainment business (LX): A management change and a new dividend policy.

Management change: The co-founder CEO, Genki Shiota, who was the creative co-founder, is being removed from the role and will now be a non-executive director and “Heart Driven Coach,” while Tetsuro Koda becomes CEO. Koda was a co-founder and a programmer. This fundamental change at the top will be bolstered by the creation of an Executive Leadership Team (ELT). They call it a shift from a founder managed to team managed strategy. The ELT will work with the board consists of the following:

This change should be positive. It is almost as if an activist entered and shook up management in order to refocus the business with operating profit in mind. We estimated a few billion yen operating loss in FY19 for LX (they only tell us the non-game operating loss that includes corporate overhead).  It appears the operating loss didn’t get worse in yen terms in FY20, but perhaps the return potential after a year just wasn’t there.

(Note: FY18 and FY19 above refers to the respective years ended March 2019 and 2020)

They changed the dividend policy: They used to say that shareholders were rewarded when they reinvest in growth areas. Well, the policy is now that they will pay out 3% of shareholder equity, half as a mid-term payment and half as year end. It sounds like they choked off the growth reinvestment in LX that wasn’t working, so they are returning capital to shareholders while they continue to invest in operating expenses for game development.

In the earnings release, they said, “For the fiscal year ending March 31, 2021, approaching our 10th anniversary, we aim to further strengthen the development and operation of mobile games, which have been our Company’s greatest strength since its foundation. Moreover, we aim to create IP and develop mixed media, to “pivot on games and become an IP production company” through efforts in new game experiences, and to achieve global expansion that will drive our next phase of growth.”

Looking at the chart above, we continue to see that the other risk we identified – the existing games dropping off faster than new ones ramping – is getting better. The biggest delta for operating income is the investment in the games business primarily on new titles.

FY20 sales were +14% to 32B from 28B driven by contribution from multiple game titles. Operating profit of 11B was down 19%, again mostly due to investment in the games business. When we flow the EBIT to net income, we exclude the various other income/expense and extraordinary items lines. Therefore, our operating net income estimate for FY20 is 7.4B, down from 9.0B last year. The new dividend policy means that that the expected dividend this year is 60 per share or 1.4% yield.

Outlook: Management doesn’t give guidance, but they do say what their focus areas are: Maximize long-term value of existing games, release on new title, publish an overseas version of one title, invest in IP creation, focus on profitability for LX. The latter alone would be an estimated few billion yen tailwind to EBIT if it got to breakeven.

Valuation:

At JPY4,000, market cap is about JPY56B. More than half of this market cap is cash of 26B and investments of 6B. Debt is 8B so enterprise value is about 32B. FY19 EBIT was 13.6B and FY20 EBIT was 11.1B We use a somewhat arbitrary 12x EV/E on 7.4B of net earnings to get roughly 8,100 stock price. See below for P/E, EV/E, EV/EBIT, P/FCF, EV/FCF.

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.

Catalyst

- One of their shots on goal scores, i.e. new games

- Improving capital allocation