Description

Disclaimer: while we are long Embracer, this is a very new position for us and we’re not 100% there in terms of conviction. We welcome VIC feedback / comments as part of our research process.

Embracer has been over the last 2 years the dream of every short seller: empire-building, overly bullish CEO pursuing an aggressive M&A roll-up strategy with little strategic rationale, all dressed with aggressive accounting. Several funds expressed concerns about Embracer business model and accounting practices, all reported in a couple of FT articles that partially contributed to the share price halving from c. 120SEK to 60SEK over the last 2 years. Things got particularly interesting as the stock price fell another 60% to 23SEK at the time of writing due to a particularly disastrous earnings release on Wednesday May 24th. Lars Wingefors, Embracer CEO and largest shareholder has been signaling a “transformative”, “game changing” “mega deal” with a mystery player for nearly a year; such deal would have all but guaranteed $2bn in incremental revenues over 6 years, underpinning a 2023-24 EBIT original EBIT guidance (at mid-point) of SEK12bn. On Tuesday night, this phantom industry player communicated to Embracer their intention not to proceed with the deal, notwithstanding a verbal commitment given in October 2022. Overnight, Lars had to cut 2023-24 EBIT guidance by 33% to c. SEK8bn. His credibility is now in tatters. Watching the Q&A session is actually painful, Lars seems to be crying:

https://twitter.com/stephentotilo/status/1661369938114650112

We believe the above set of events created a very attractive risk reward for the shares. We believe some of the assets accumulated by Embracer over the years are high quality and more than covers the current market value. We believe that while some of the aggressive accounting criticism is legitimate, there is no fraud here and the majority of the accounting adjustments are appropriate. Finally, and perhaps more importantly, the wild M&A strategy fueled by debt and equity has come to an end. The share price is just too low to justify any further capital increases and the Board is set to bring leverage below 1.0x Net Debt to EBIT before considering further larger acquisitions.

Similarly to META in the last 6 months, we believe the Embracer story is changing from a “growth at all costs” one to an “execution” story. Given the valuation dislocation, we believe the margin of safety to be wide and see at least a doubling of the share price over the next 12-18 months.

Summary business description

Embracer went public in 2016 with the name THQ Nordic. As per Prospectus, “THQ Nordic acquires, develops and publishes PC and console games for the global market. The core business model consists of acquiring established but currently underperforming franchises and successfully refining them”. At its IPO, the group reported $218m SEK in sales for the latest financial year. Fast forward 7 years and nearly 100 acquisitions later, Embracer reported in FY 2023 SEK38bn in sales. The company spent to date over $10bn on M&A and nearly $2bn on game development projects. The current Enterprise Value is a little over $4bn. The value destruction has therefore been impressive.

Amongst notable M&A, Embracer bought Borderlands’ publisher Gearbox for $1.3 billion back in 2021. They also bought Crystal Dynamics, Eidos Montreal and Square Enix Montreal, along with IPs like Deus Ex, Thief, Legacy of Kain and Tomb Raider for just $300 million in 2022. In 2022 Embracer also completed the acquisition of Asmodee, a board game and card game publisher with blockbuster games such as Catan and Dixit. It was purchased from PAI for over EUR3bn, or c. EUR240bn in EBITDA.

As a result of all these transactions, Embracer today operates in 4 different divisions which include 13 distinct operative groups that are truly decentralized. Embracer operates almost as a holding company for the companies they own, giving them financial support and resources to grow and strive.

PC / Console Games

It’s by far the largest and most profitable segment of the group. It represents c. 1/3 of group EBIT. Following numerous acquisitions, it operates now 7 distinct groups:

·         THQ Nordic – this is the original gaming group that listed in 2016. Headquartered in Vienna, it owns over 20 Studios and the IP of known brands such as ELEX, Darksiders, Biomutant and Wreckfest

·         Plaion - Founded in 1994 as Koch Media, PLAION is a leading independent developer and producer of games and entertainment products. PLAION has a family of 10 development studios based around the world and five games publishing labels: Deep Silver, Prime Matter, Ravenscourt, Milestone and Vertigo Games. Plaion has just released the AAA game Dead Island 2 on April 21st, 2023

·         The Coffee Stain Group became part of Embracer in November 2018, forming the 3rd Operative Group. Coffee Stain is an indie game developer and publisher of PC, console and mobile games. Particular strengths in creating new products include its focus on digital sales, retention, cross platform and multiplayer

·         Amplifier became part of Embracer in August 2019, forming the 4th Operative Group. Amplifier operates as an IP “incubator” of sorts. It’s Embracer’s vehicle for investments in new IP-development and teams. The business is based on a partnership model designed to attract top talents through incentives and commercial support from the Group, while leaving them full creative integrity

·         Saber Interactive became part of Embracer in April 2020, forming the 5th Operative Group. Saber generated nearly SEK1bn in sales and 65% EBIT margin when acquired by Embracer. It does lots of royalty-based project for big brands such as Halo, The Witcher, World War Z, Evil Dead

·         Gearbox was acquired in February 2021 for $363m in cash and shares plus another $715m in earn outs. At the time, this was Embracer’s largest acquisition. In order to hit the full earn-out, Gearbox is to hit $368m in EBITDA by 2027. For reference, this alone would represent 40% of total Embracer EBITDA 2023.

·         Crystal Dynamics + Eidos – these 2 studios are amongst the most respected AAA producers with blockbuster titles such as Tomb Raider, Deus Ex and Thief. Embracer paid $300m for these studios

Overall, the segment is growing rapidly (+10% organic growth in 2023) with historically high margins. EBIT margin dropped in 2023 from 34% to 22% on the back of some delays in releases and some disappointing acceptance of some new games.

Mobile

The division operates through 2 distinct operative groups:

·         Deca – acquired in August 2020. DECA Games is an ecosystem of mobile publishers and developers with an expertise in live operations of Free-to-Play games. It was paid EUR25m + EUR60m in earn-outs

·         Easybrain – Purchased in February 2021, Easybrain is a developer of best-selling mobile logic puzzle games that have been downloaded more than 1 billion times and are played by more than 16 million users daily. The company’s portfolio includes a variety of market-leading games, such as Sudoku.com, Nonogram.com. Blockudoku, Jigsaw Puzzles, Art Puzzle, Number Match, and more. AI could provide a big tailwind to this segment as AI generated puzzles have proven to be very successful

The segment has grown to account for a sizable share of Embracer Group’s business. The Mobile Games segment includes free-to-play, ad centric, in-app-purchase centric and pay-to-play mobile games. It had a tough 2023 with organic sales decline of 13% (-36% in Q4-23 alone). There is little visibility in this segment, and it appears Embracer mismanaged some of these acquisitions. The entire monetization of these games is digital

Tabletop games

The division includes all the assets of Asmodee, the largest acquisition to date, paid over $3bn by Embracer in 2022. We shall discuss Asmodee in more detail below as we believe to be an underappreciated asset in the Embracer portfolio. Nearly 100% of tabletop games are physical.

Entertainment & Services

The Entertainment & Services segment consists of three operative groups:

·         Plaion - The segment also includes PLAION´s partner publishing and Film businesses. The rationale (still unproven) was to generate incremental IP dollars from successful gaming franchise through deals in the entertainment industry (e.g., movies)

·         Dark Horse Media – bought in March 2022, is a publisher of comic books like Hellboy and the Umbrella Academy

·         Freemode - is a diverse mix of companies, including Middle-earth Enterprises and Limited Run Games as well as companies active in different parts of the gaming and entertainment value chain

C. 90% of Entertainment & Services sales are not digital. The segment grew 3% organically in 2023 with EBIT margins temporarily depressed (only 5% in 2023). After the period Middle-earth-Enterprises announced an agreement with Amazon Games to develop and publish a new massively multiplayer online (MMO) game based on The Lord of the Rings. Set in a persistent world, the new MMO is in the early stages of production, with the Amazon Games Orange County studio leading development. Amazon Games will publish the game globally for PC and consoles.

Asmodee

While it’s hard to gauge the value of each digital game publisher, we believe Asmodee remains the crown jewel in the Embracer portfolio. Asmodee is an incredibly diverse collection of IP in the board games and trading card games space. It’s also geographically diverse.

Asmodee operates in a very large, non-cyclical and recessionary proof market. It continues to grow at high single digits and 2024 guidance is for another year of high single digit growth:

Asmodee has a very rich portfolio of well-known brands and games, including Catan, Magic, Codenames and Bananagrams:

Asmodee margins have been very consistent over time and free cash flow conversion is very high. While we don’t think there is much scope for further cost cuts given prior Private Equity ownership, we also think it’s a very well-run business that could be easily monetized. It was purchased in 2022 for over SEK30bn. This is more than Embracer’s current market cap.

If Embracer were to have to monetize some assets to pay down debt, we think Asmodee would be an easy asset to sell, and it will have very little operational impact given the near-zero overlap with other segments of the business.

Accounting issues

On March 28th, 2023, the FT published a good and comprehensive article about accounting issues at Embracer. While nobody is accusing Embracer of fraud, the discrepancy between reported and adjusted results is so big that inevitable claims of aggressive accounting were made against the company. First of all, it’s virtually impossible to assess the true organic growth of the business with all these acquisitions. Similarly, underlying free cash flow generation of the business is equally impossible to assess. Finally, the add-back of “acquisition related personnel expenses” is causing many analysts to question the appropriateness of this adjustment. In the financial year 2023, Embracer reported EBIT of SEK194m but Adjusted EBIT 30x larger, or SEK6,366m. There are 4 large buckets of adjustments as per slide below:

·         Acquisition related personnel expenses – this is probably the most controversial accounting practice, which we’ll discuss below

·         Acquisition related amortizations – while its magnitude is clearly unusual compared reported margins, it’s an acceptable adjustment since it’s 100% non-cash

·         Transaction costs – it’s probably acceptable to add these costs back, assuming they are really one-off in nature

·         Other non-recurring items – some of those are probable recurring  

Back to personnel expenses, the issue stems from the fact that the company has to pay employees from purchased companies a sort of deferred compensation / retainer to make sure they stay with the company. The payment of these is dependent on the employees staying with the company. As a consequence, they are treated under IFRS as personnel expenses, even if they are paid only at the end of their minimum tenure. For example, as in the example below, if Embracer signed a 300SEK earnout contingent to future employment and payable only in year 4, the actual earnout is paid in year 4 but according to IFRS, a SEK100 of personnel expense is charged every year. This is distorting P&L because the charge is non-cash and it’s a one-off payment:

Because of the sheer magnitude of the M&A to date, these personnel costs have become a huge component of overall personnel costs:

The above adjustments add some SEK3bn to Adjusted EBITDA from EBITDA:

Furthermore, to make things even harder for investors, Embracer does provide a Balance Sheet figure for contingent earnout liabilities but does not provide the equivalent for personnel costs liabilities. A further complication arises from the fact that some of the contingent liabilities are payable in cash and some in shares.

The way we think about contingent consideration is effectively to capitalize it on the balance sheet and exclude these costs from the P&L. Furthermore, we would assume cash liabilities as financial debt and liabilities in shares as equity to be issued. We therefore assume that Embracer will have to issue all those shares and look at diluted number of shares post earnout dilutions.

We calculated a total of SEK11.5bn of cash / financial debt which has to be added to balance sheet debt and a further SEK3.7bn in contingent consideration which will be settled in shares and is therefore included in the diluted total number of shares.

Reported Net Debt as of 31/03/2023 was SEK15.5bn. We add SEK11.5bn for a total adjusted Net Debt of SEK27bn.

Valuation considerations

Factoring an adjusted Net Debt of SEK27bn after contingent consideration adjustments, and with a fully diluted number of shares equal to 1,367m, Embracer’s EV is equal to SEK57bn, or c. 6x EV / EBITDA 2023. Another way to look at it is to peg the value of Asmodee at c. SEK30bn (the price paid for it) and create the rest of the group at SEK27bn. On an adjusted EBIT basis, the rest of the group excluding Asmodee generates adjusted EBIT of approximately SEK4.4bn and adjusted EBITDA of approximately SEK7.5bn. We are therefore underwriting the digital gaming business at c. 6x Adjusted EBIT or c. 3.5x Adjusted EBITDA. Is this low enough? It’s hard to tell but we believe there are some valuable assets in the mix, including:

·         Plaion – exhibiting consistent growth with revenue exceeding EUR600m in 2023

·         Dark Horse – incredibly rich IP collection generating in excess of SEK1bn in sales at high marginality

·         Gearbox – established experience in AAA games, Adjusted EBITDA target in excess of $300m in 2027

·         Easybrain – world leader in mobile puzzle and logic games

·         Saber Interactive – the company was generating well in excess of SEK1bn in sales and very high marginality (c. 60% EBIT margin) when acquired by Embracer in 2020

While it’s very hard to underwrite a clear valuation floor for the collection of assets gathered to date, we think there are several valuable assets giving investors upside optionality. We believe the M&A craze has come to an end as the market is unwilling to trust Lars with further M&A until the ship has steadied. Furthermore, Lars is very much incentivized to get the share price up to avoid further losses of talent. Finally, recent shareholder activism by local Nordic funds will probably add further pressure on Lars to make some tough decisions in order to create value.

At current prices and assuming Adjusted EBITDA at the low end of FY2024 guidance, Embracer trades on c. 6x EV / EBITDA, including full dilution from earn outs and treating all contingent considerations as debt:

While other AAA game publishers such as Activision Blizzard, EA and Take Two are unquestionably better businesses and therefore trade at premium valuations, the valuation dislocation appears too high.

Applying an exit 6x EV / EBITDA multiple valuation, we get over 100% upside over next 3 years:

Catalyst

No M&A for a while