Description

I recommend selling short shares of Pearl Abyss, a Korean video game developer and publisher. The stock has already been a great short since late 2021 (down ~65%), but I believe there remains another 50% downside.

Company Overview. Pearl Abyss was established in 2010 with its own proprietary game engine and the ambition to develop AAA MMO games. It successfully launched its first IP, Black Desert, in 2015. Today, Black Desert has over 40 million players in 150 countries across PC, console, and Mobile, and has generated over $1.5bn in cumulative sales. The game monetizes differently across each platform with mobile being free-to-play with in-game transactions, while PC and console require an upfront purchase plus in-game transactions. In attempt to diversify its revenues Pearl Abyss acquired CCP games in September 2018. CCP is the developer of EVE Online, a popular space based MMO that was launched in 2003 and has a loyal community of players globally (80% of players have played for 3+ years). Despite the acquisition, Pearl Abyss still generates ~80% of its revenue from Black Desert.

Investment Thesis:

I believe there remains a second leg to the short thesis as the player engagement metrics for Black Desert and Eve Online have not meaningfully rebounded. While shares are currently trading on “only” 26x Street estimates for next year, they are on 47x trailing earnings. The set up remains the same but with the overly optimistic growth expectations having now shifted from Black Desert Mobile in China to two upcoming games, Crimson Desert and DokeV. I believe both are unlikely to live up to these expectations, and at current prices, shares do not reflect the possibility for even a minor disappointment.

Black Desert player engagement metrics remain weak. Black Desert accounts for ~80% of revenue. No matter how you track it, the IP’s engagement remains near all-time lows.

MMOpopulation.com:

Steamcharts:

Google Trends:

Crimson Desert Expectations are too high. Crimson Desert is an upcoming AAA open-world action/adventure game slated to launch at an unknown date in the fall of 2023 after a series of delays. The trailer looks impressive enough, but it’s a competitive genre and the game doesn’t appear much different from the numerous upcoming releases from the big AAA competitors in 2023/2024. I believe 2H23 to be a particularly competitive AAA gaming environment with the long-awaited releases of highly anticipated games like Final Fantasy XVI, Diablo 4, Skull & Bones, and Starfield. Truthfully, I don’t really have any special insight on whether the game will be able to stand out in this crowd, but it is incredibly difficult to launch a successful new AAA IP as development costs continue to rise and gamer’s attention spans are short. Furthermore, I believe that the traditional AAA single player games like this are simply unattractive from a business model perspective. Without rehashing too much of my previous CDR short thesis, the business model is highly cyclical and hit-dependent even for the best developers.

I believe the Street estimates imply over 4mn units of Crimson Desert to be sold in its first year. While that may seem like nothing compared to recent AAA commercial hits like Cyberpunk 2077 and Elden Ring (12+mn units sold), these were both highly anticipated releases from studios with phenomenal multi-game track records. They even had celebrity assistance from Keanu (Cyberpunk) and George RR Martin (Elden Ring). I think a more realistic baseline for a successful new IP is something like Remedy’s Control which won a number of awards and has sold over 3mn copies since its 2019 release. Another interesting comparison is The Callisto Protocol from fellow Korean developer Krafton, which was recently released in December and has struggled greatly. The company now expects to sell 2mn units (originally 5mn). From what little information I can find the game has so far struggled to break past 800k units sold. By my math, if Crimson Desert sells only 2mn in 2023 then revenue will come up 25% short to expectations, and at 1mn its ~35% short.

DokeV expectations are also too high. The second game in Pearl Abyss’s pipeline that has generated significant buzz is DokeV. It gained the market’s attention in August 2021 with the exciting trailer mentioned earlier. The company recently delayed its launch until 2024 at the earliest. The game was originally thought to be another live-service MMO, which was exciting for investor’s as MMOs have proven to be phenomenal long-term monetization models compared to the traditional model of the industry. However, the company has walked back those expectations and now claims it will be a single-player action/adventure game with multiplayer elements. This reminds me of the Cyberpunk 2077 which was also originally thought to include an online mode like GTA Online before CD Projekt backtracked and eventually removed multiplayer altogether. Another single-player game is much less exciting from an investment perspective and as new IP likely faces the same issues described above for Crimson Desert.

Valuation. The table below compares Pearl Abyss’s valuation with its publicly traded Korean gaming peers.

Outside of Netmarble and WeMade, which each have their owns company specific issues, Pearl Abyss is trading at an extremely high valuation relative to its Korean gaming peers. A pushback might be that margins are temporarily low due to the investments in these new games. But even if you were to take margins back to 2019 levels, Pearl Abyss is trading at >30x P/E. The company absolutely needs successful releases from the games above to justify its valuation.

I think Krafton is an apt comparison here. It also has a very strong core IP in PUBG that faded over time and has seemingly found a floor. Like Pearl Abyss is attempting, it has tried to find the next leg of growth through mobile expansion of its core IP (PUBG: NS) and single-player AAA games (The Callisto Protocol). As these attempts have failed the stock has experienced the one-two punch of multiple compression and downward earnings revisions. The company is now trading on 16x the earnings from what is essentially its core IP alone, despite a pipeline of new games. I believe it is likely Pearl Abyss follows this same path. A similar multiple on its normalized earnings from Black Desert and Eve Online implies 50% downside from here.

Catalyst

Earnings revisions from further delays or lowered expectations