Description

Long: Endor AG (E2N)  

Thesis Summary

Endor AG is a long. Endor is an under-the-radar German small cap with a dominant competitive position in a rapidly-growing end market trading at an attractive valuation due to non-fundamental factors. The company is already considerably profitable, is asset-light with high returns on capital (40%+ with very little incremental capital required to grow) and is net cash (pro forma for end of year 2019 balance sheet). It compounded revenue from 2007-2018 at a 47% CAGR, grew revenue 78% in 2019 and 90.5% in 1Q20, and by all indications has seen growth accelerate even further as a result of the COVID pandemic. Additionally, looking beyond this year, we believe there’s a long runway for continued revenue growth over many years driven by multiple levers. Despite these attractive features, the stock today can be bought today for just ~20x our estimate of 2020 earnings as a result of several non-fundamental factors; namely, a lack of any analyst coverage, listing on secondary, regional German exchanges, sparse investor communication and no outbound marketing efforts, illiquidity, limited financial disclosures and absolutely no English-language disclosures. While the stock has had a significant run as of late, we believe that investors can underwrite ~70% upside (~30% IRR) through 2022, with the potential to continue to compound at attractive rates thereafter given that the company will still have a significant opportunity ahead of them by that point. There are also several catalysts that could potentially spur a re-rating, including implementation of quarterly reporting, publishing financials in English, and uplisting to a major exchange. However, even in the absence of a re-rating, we believe that the underlying growth alone will drive attractive returns. 

Business and Industry Overview

Endor In Brief

Endor develops and markets high-end “sim racing” hardware accessories, including wheels, pedals, shifters, etc. that it sells under the trade name Fanatec (pronounced identically to “fanatic”). The company was founded in 1997 by Thomas Jackermeier (who is still CEO today and owns ~44% of the company) and went public in 2006.

Sim Racing Market

Sim racing (think F1, NASCAR, and other motorsports but entirely simulated in video game form on PCs as well as Xbox and PlayStation) has emerged as a fast-growing hobby and eSport, with even actual F1 drivers beginning to participate in sim racing leagues and using racing simulators as part of their training.

Unlike video game versions of other sports (e.g. Madden, FIFA, NBA 2K), which are highly artificial imitations of the real sport where actions are performed by pressing buttons on a video game controller, sim racing games are hyper-realistic simulations of the real sport and require essentially the same set of skills as real-life driving. Racing simulators have over time evolved to feature highly sophisticated physics engines that accurately replicate the experience of driving, including mimicking all of the variables involved (from vehicle performance, handling, and aerodynamics all the way down to minutiae such as weather, fuel usage, tire wear, etc.). Indeed, sim racing has evolved to the point where some sim racers have defeated professional drivers in live racing events. Not surprisingly, sim racing is a highly competitive activity, with racers competing for the best lap times and in head-to-head competitions.

Sim racing hardware plays a key part in enabling this realism. To provide just one example, advanced sim racing wheels feature “force feedback,” where electric motors in the wheel base are used to simulate the same torque in the steering wheel as one would feel in a real car, which is critical for drivers to be able to feel the grip limit of a car and detect changes in the road surface. So rather than being a “peripheral” that is merely incrementally additive to gameplay, sim racing hardware is deeply intertwined with the player’s experience and a critical element of gameplay.

These are expensive, high-tech products, with Fanatec’s racing wheels staring around ~€500 and bundles often costing €1,000+. This is also on top of other equipment that consumers need to purchase, such as a high-end gaming PC, games, monitors, etc. Needless to say, the total cost of entry is steep.

Competitive Landscape and Fanatec’s Positioning

Fanatec offers products in the premium end of the sim racing hardware market, and essentially owns this entire portion of the market (though there are a few niche competitors such as Simucube and AccuForce that focus on particular components). The two largest competitors are Logitech and Thrustmaster (owned by parent company Guillemot), but these companies generally focus on the entry-level and mid-tier markets. The typical pattern of purchase behavior is for a consumer to start with cheaper products such as Logitech’s and then gradually upgrade to higher-end equipment such as Fanatec’s. 

Fanatec sells its products modularly (e.g. wheels can be purchased separately from pedals and shifters, and customers can upgrade one component of the set-up to a more advanced model without having to change out the other components), and all of the company’s products are compatible with one another (which is often not the case if one mix and matches products from multiple vendors) and thus form a cohesive ecosystem. Over the years, the company has developed a sterling reputation in the sim racing industry and has established itself as the aspirational brand of choice for most consumers.

Manufacturing/Distribution Model

Fanatec operates a capital-light business model. All manufacturing is outsourced to third-party manufacturers in Asia, with design and engineering functions performed in-house. Almost all sales take place through their e-commerce website. Furthermore, working capital needs are minimal, as the company is paid up-front but ships the product days later, and inventories are relatively lean. All told, this translates into 40%+ returns on invested capital.

Historical Growth and 2020 Outlook 

Historical Growth

Before delving into our outlook for revenue growth, it’s first worth recounting the company’s historical growth and the factors behind it.

Between 2007 and 2019, Endor grew top-line from €0.3mm to €39.4mm, an impressive 49.3% CAGR (albeit off a fairly low base).

Endor’s growth has largely mirrored the growth in the broader sim racing market, which has been driven by a number of factors:

• Improvements in the quality of sim racing technology: As sim racing technology (both software and hardware) has improved, sim racing has come closer to matching the real thing. In addition to improvements in the realism of games’ physics engines, games have also seen significant improvements with respect to visual and sound quality and have also benefited from the advent of VR equipment for video games (significant for sim racing because it allows users to look around corners as they would while driving normally). These advancements have vastly improved (and will continue to improve) the quality of the sim racing experience, drawing in more users and making it much easier for would-be sim racers to justify the high price tag of the necessary equipment. Furthermore, the most competitive sim racers that seek to maximize every possible competitive edge habitually upgrade to the latest hardware.
• Increased promotion by traditional racing leagues and OEMs: Over the last ~2 years, traditional racing leagues and high-end auto OEMs have begun to establish and sponsor sim racing leagues and teams as a way to increase fan engagement outside of traditional motorsport events. Most notably, F1 established a parallel sim racing series (the Formula One Esports Series) in 2017, with the first full season taking place in 2018.
• Growing popularity of eSports: Sim racing has also been a beneficiary of the wider rise in popularity of eSports and streaming (e.g., Twitch).

Importantly, growth has accelerated significantly over the past year or so. Revenue grew 78% y/y in 2019, and 1Q20 revenue grew 90.5% y/y (note that while the company doesn’t file full quarterly financial statements, they do provide press releases disclosing quarterly revenue, a fact which has probably contributed to this growth going largely unnoticed by the broader investor community). This acceleration is due in large part to the aforementioned promotion of sim racing by traditional racing leagues and OEMs, which has helped to introduce sim racing to a broader audience of mainstream motorsports fans beyond the hardcore gamer demographic the market was historically confined to.

Near-Term Outlook  and COVID Impact

While Fanatec was already experiencing an inflection in growth even prior to the start of COVID, all indications suggest that sim racing and Fanatec have seen a further massive acceleration in growth as a result of COVID. Like the rest of the video game industry, sim racing has seen a massive surge in demand as lockdowns force people to seek stay-at-home entertainment options. Additionally, with motorsport leagues cancelling or postponing events as a result of the pandemic, sim racing has begun to fill the void left by the dearth of live racing events. F1, for instance, launched the Esports Virtual Grand Prix series in late March of this year. Similarly, NASCAR held the eNASCAR iRacing Pro Invitational Series in collaboration with iRacing (one of the most popular sim racing games). All of this has brought increased visibility to sim racing.

Below are just a few datapoints illustrating the explosion in interest in sim racing and the Fanatec brand have seen as a result of COVID:

• Google Trends:  Fanatec search interest in April, May and June is tracking at 2.0x-3.5x prior-year levels (even after tapering off in mid-April).

• iRacing Subscriptions: iRacing, a popular subscription-based sim racing game, grew paid subscribers from 110,000 at the end of 2019 to 160,000 by mid-April (a ~45% increase in ~3.5 months).
• r/simracing Subreddit Members: Members of the r/simracing subreddit have grown +36% since the end of 2019 and +80% y/y.

Beyond these softer metrics, we also have a number of more concrete datapoints that point to a massive surge in order volumes for Fanatec over the last several months.

• Mask Donations: In early May, Endor donated 500,000 face masks to the German city of Landshut (where the company is headquartered) and pledged to donate an additional mask for each purchase made on the Fanatec website. For a brief period, the company provided a counter on its website that displayed the number of masks donated. While this counter is no longer on the website, by using archives from the Wayback Machine, we can track the progression in the number of mask donations in order to estimate the number of orders received per day. Between May 12 and May 18, the counter increased from 521,695 to 526,906 (note that the counter was updated in real time, so the time of day also makes a difference here), suggesting orders per day averaged somewhere in the 850+ range during this period. Even assuming a haircut to this number and an average revenue per order of €500 – likely conservative given that wheel/wheel bases for its cheapest line of products (CSL) go for €450+, to say nothing of the pedals and shifters that many users would also purchase – would imply €30mm+ in 2Q20 revenue, or 200%+ y/y growth vs. the €10.6mm of revenue that Endor generated in 2Q19.

   

• CEO Blog Post: On June 7, Endor’s CEO posted a message on Fanatec’s official blog. The post, which was in response to several customers experiencing delays in the shipments of orders and slow responses to technical support / service inquiries, indicated that the company has seen a massive surge in order volumes in recent months. Specifically, the CEO stated that order volumes on some days were as much as 5x higher than January levels (which were already 60% higher than prior-year levels), and that demand levels have remained at 3x what the company had planned. While it’s important not to downplay the significance of the issues that some customers are experiencing, the level of demand cited by the CEO (which seems to be supported by all other available datapoints) implies an absolutely massive y/y revenue increase in 2Q20 and, furthermore, seems to indicate that high levels of demand have persisted through the date of the post (June 7). I’ve included the relevant excerpt below:
  
  “Since March we are getting an unusual and unexpected amount of orders. This has to do with the lock down but also with the increased promotion of sim racing as replacement for the real life race events. […] The orders on some days were suddenly five times higher than in January and the January numbers were already 60% above the previous year. […] [T]he demand is still crazy high and still three times higher than what we planned.”

So, to recap: Endor’s growth trajectory already saw a massive step-change before COVID, and has only inflected further as a result of the pandemic. 2Q revenue appears likely to grow somewhere in the order of 200% y/y, and it appears that much of this momentum has been sustained through June going into 3Q. It’s also worth emphasizing that approximately 50% of Fanatec’s orders (and approximately the same amount of revenue) come from repeat customers. As such, the significant growth that Fanatec has already seen should provide the foundation for sustainably higher earnings power going forward.

Long-Term Growth Runway

While there’s significant evidence that points to robust revenue growth over the near-term, I believe that even following what should be high double-digit / low triple-digit year-over-year growth in 2020, the company will have a long runway for further revenue growth going forward. At a high level, our qualitative diligence from conversations with industry participants suggests that interest in sim racing from both fans and motorsport leagues / auto OEMs using sim racing as a marketing tool has reached a tipping point and that the growth seen in recent months is just the beginning. On top of continued growth in the overall sim racing market, there are a number of levers that support continued top-line growth in 2021 and beyond.

• Expansion down-market: Today, Fanatec exclusively sells products that address the premium end of the sim racing hardware market. Based on our conversation with the company (and as confirmed by discussions with simracing experts), this portion of the simracing market accounts for just ~5% of the industry’s total units (though revenue share is obviously higher given higher ASP). Going forward, the company plans to expand its range of products to address consumers further down-market. Indeed, the company has already taken its first steps as part of this strategy with the introduction of its CSL line of products. While the CEO wants to be careful not to dilute the brand’s quality reputation and will never go after the entirety of the market (during our call, the company analogized their strategy to Mercedes’ expansion from the S-Class to the C-Class and eventually the A-Class), their low penetration today nonetheless suggests significant room to grow revenue by broadening the range of price points addressed by its product portfolio. This also has the added benefit of bringing customers into the Fanatec ecosystem earlier.
  • "We have about 30 new projects which wait for completion as we plan a massive product launch to expand our product portfolio in all directions. Stay tuned.” – Thomas Jackermeier, post on official Fanatec Blog
• New simracing fans migrate their way up the funnel: Based on my diligence, most new sim racers don’t immediately purchase high-end hardware such as that offered by Fanatec. Instead, they generally initially purchase entry-level hardware (such as that offered by Logitech and Thrustmaster) and gradually upgrade to higher-end equipment over time. This suggests that Endor has yet to capture the full benefit of the significant number of new sim racing fans brought into the market over the last 1-2 years (including the huge increase in fans brought in as a result of the coronavirus over the last ~3 months), most of whom are more casual fans that have yet to migrate their way up the scale. Put another way, we think that the tailwinds from coronavirus will be a longer-duration tailwind than one might initially assume (though clearly there’s already been some impact on Fanatec’s business).
• Geographic expansion: Endor currently sells its products primarily in Europe, the United States, Canada, Australia, and Japan. As such, there’s a significant opportunity to grow revenue by selling its product in additional regions, most notably China (the world’s largest gaming market and one in which Endor has only a de minimis presence today).
• New console generation: The PlayStation 5 and Xbox Series X (the next generation of Sony and Microsoft’s consoles following the PlayStation 4 and Xbox One) are due to launch during this year’s holiday season. Historically, the console makers have not offered backwards compatibility for licensed peripherals. This means that consumers need to buy new wheels in order to play games on the new consoles. This should provide a strong tailwind to growth in 4Q and 2021. For sake of comparison, in 2014 (the first full year following the release of the PS4 and Xbox One), Endor’s revenue grew 109% y/y.
• Expansion into adjacent product categories: While Endor has built a leading position in the market for core sim racing hardware components (wheels, pedals, shifters), there exists low-hanging fruit from expanding its offerings in adjacent product categories such as cockpits/rigs in which it has only a small presence today.
• Robust game pipeline: While Endor’s sales growth over the long-term has followed the trajectory of interest in sim racing, revenue growth in any given year is highly influenced by the set of sim racing games released that year. For example, revenue in 2017 grew 67% y/y as a result of the release of three high-profile sim racing games: Project CARS 2, Forza Motorsport 7, and Gran Turismo Sport. 2020 is set to see the release of Project CARS 3 (releasing in summer of this year), and Gran Turismo 7 and Forza Motorsport 8 are expected to be released in 2020/2021 (likely coinciding with the approximate launch dates of Sony and Xbox’s new consoles).

Ample Catalysts To Spur Re-Rating

While underlying growth alone should drive very attractive returns for equity holders over a multi-year time horizon, I believe that there are a number of catalysts that could accelerate the timing of value realization. As mentioned at the beginning of the write-up, Endor is overlooked today principally as a result of limited disclosures (including no quarterly financial statements, no cash flow statement, and a total lack of any English-language disclosures), listing confined to regional German exchanges, and similar non-fundamental factors. While the CEO’s focus is first and foremost on operating the business and executing on the large opportunity in front of it, he is mindful that improved disclosures and listing on a major exchange would go a long way towards attracting additional investor attention. The company is actively considering implementing quarterly reporting, and the CEO has suggested that English disclosures/financials would be relatively easy to roll out given that English is already the primary language the company uses internally. The company has also put thought into uplisting to a major exchange, and while this appears to be less of a near-term priority than quarterly reporting and English disclosures, I would expect this to happen eventually. 

Given that this is a small cap with no essentially no meaningful US/non-German investors, there are still a large number of potential incremental buyers here, and as such improved disclosures and investor communication could result in a material valuation uplift.

Valuation and Estimates

This is a relatively simple business to model from a conceptual standpoint. The key drivers here are revenue growth and the consequent operating leverage as the company grows on top of a moderately fixed cost base. Little incremental capital is required to accommodate growth as manufacturing is outsourced, and this outsourced manufacturing model combined with lean inventories and up-front payments from customers means that the company should generate robust FCF relative to earnings. My base case assumptions are outlined below.

• Revenue:
  • 2020: Given 1Q20 revenue growth of 90.5% y/y (which largely reflected pre-COVID demand) and the datapoints outlined above, 2Q revenue appears likely to grow 200%+ y/y. For purposes of my model, I assume that 2Q revenue grows 200% y/y before modering in 2H20 to 50% (significantly below the growth rate in 2019 and 1Q20 and essentially in-line with the company’s long-term CAGR, despite 2H20 likely seeing continued benefit from COVID and benefitting from the launch of next-gen consoles). These assumptions drive full-year 2020 revenue growth of ~95% y/y.
  • 2021-2022: I assume 25% annual growth in both 2021 and 2022. Given that the company has compounded revenue at a 50% CAGR over the last 11 years, the significant runway for growth from product and geographic expansion, the benefit from the launches of new consoles and several marquee sim racing titles, and the ongoing adoption of eSports and sim racing, I see 25% annual growth as eminently achievable.
• Margins
  • Gross Margin: I assume that gross margins remain flat. The company’s manufacturing is predominantly outsourced to third-parties in Asia. While the company could likely extract better terms from its suppliers as it grows revenue, I conservatively contemplate no benefit from this.
  • Personnel Expense: My estimates bake in a fair amount of operating leverage with respect to personnel expenses. Given the small size of the company, management compensation (an inherently fixed cost) still represented ~18% of personnel expenses in 2019. Simply assuming that management compensation remains largely fixed in conjunction with the revenue growth estimates detailed above provides a ~150bps margin tailwind from 2019 to 2022. Additionally, while the company will have to hire additional technical support and service employees roughly in proportion to increases in revenue, headcount in functions such as engineering and design roles shouldn’t have to scale significantly as revenue grows.
  • Other Operating Expenses: This consists primarily of marketing costs and royalties associated with special products affiliated with brands that Endor has entered into partnerships with (e.g., ClubSport Steering Wheel F1). While these costs are largely variable in nature, the company should see some leverage on marketing expenses (especially seeing as much of the increased demand is being driven by external forces and the fact that ~50% of the company’s revenue comes from repeat customers). Note that the company has also made considerable one-time investments in systems, training, and software over the last year. I assume 50bps p.a. of annual margin expansion related to this expense item.
  • Tax Rate: I model the company’s income tax rate increasing from 15% to 20% (note: German corporate tax rate of 15%).
  • As a very rough sanity check, Logitech earns gross margins of ~37% and EBITDA margins of ~13%. This suggests that Endor (with its 50%+ gross margins) could earn EBITDA margins in the mid-20s or low 30s if it could operate at the same level of operating efficiency as Logitech. While this is by no means my base case, it serves to highlight just how much room there is for margins to expand from current levels.

Even accounting for the illiquidity and less-than-ideal disclosure (for now), one could easily justify a 20x multiple in light of the company’s growth trajectory, dominant competitive position, and the quality of the business (high returns on capital, significant portion of revenue/earnings from repeat customers, etc.). On my base case estimates, I arrive at a target price of €195 in 2022, representing ~70% upside and a ~30% IRR. My valuation approach also gives no credit to the company’s interim cash build.

Equally important, I believe the risk of permanent capital impairment is relatively low, as the company essentially trades at a market multiple on my 2020 earnings estimate despite being vastly superior to the average business in every material respect with the exception of the robustness of their disclosures (which of course is the reason the opportunity exists, and in any case is something that I expect to be addressed over time).

Risks

• Company is unable to cope with increases in demand and encounters further service
• Illiquidity
• Lack of disclosure

Catalyst

Continued growth; improved disclosure; uplisting