Description

Square Enix Q1 FY23 Commentary – Transformation Still on Track
August 10, 2023

Square Enix’s Q1 FY23 results surprised the market. However, we believe the stock has overreacted to a classic “kitchen sink” quarter, in which the company missed expectations because of higher-than-expected spending on the development budget of the HD Games subsegment.

To review, Square Enix’s HD Games subsegment has been a drag on overall Group margins for over three years. In the past, it had been defined by bloated budgets, slow development cycles, and failed new titles. Management’s turnaround efforts began in the summer of 2022, when they sold their underperforming global studios (1,100 employees and 3 studios) to Embracer Group and re-oriented their development / publishing processes. When Mr. Takashi Kiryu assumed the CEO position in March 2023, he promised to shake things up at HD Games even further. The new HD Games segment now taking shape is defined by disciplined budgets, faster content cycles, and a focus on core franchise / back catalog sales.

The recent decline in Square Enix’s stock price implies that the market is now extrapolating HD Games’ past results indefinitely into the future, that Square Enix can’t meet its full-year operating profit guidance, and that there is a zero percent probability of success for the HD Games turnaround thesis. As a result, the company trades today at a depressed relative valuation (+60% discount to its peers) and a rock-bottom absolute valuation (~7.5x EBITDA).

We 100% disagree with the market’s sentiment. Three factors give us comfort that our contrarian take is right:

1. Square Enix amortized the entire development budget (~$125 to $200m) of Final Fantasy 16 (FF16) in Q1 FY23. As a result, going forward the continued sales of this title will effectively go straight to the bottom line. These FF16 sales are primed to benefit from an especially long sales cycle, as this is a major growth year for PS5 consoles (which should rise from their current ~38 million units to 60 million units). Market participants do not appreciate this atypical setup—and therefore they do not fully appreciate FF16’s potential to drive earnings for HD Games.
2. Under the company’s new leadership, Square Enix’s pipeline is now focused on driving high “risk-adjusted” profitability, with a focus on core franchises and back catalog sales over speculative new titles. This pipeline includes Final Fantasy 7 Ever Crisis in 2023, Final Fantasy 7 Rebirth in early 2024, and a major expansion for Final Fantasy Online: Dawntrail in Summer 2024.
3. Under its new CEO, Mr. Takashi Kiryu, Square Enix has emphasized earnings as the company’s immediate and top priority. Tellingly, the company has left its full-year operating profit guidance unchanged after the Q1 FY23 results. This is the first time we have observed the company being this vocal about driving earnings growth, and we believe it speaks to the direct impact Mr. Kiryu is now having on transforming the company into a lean, focused global video game company.

Other than the HD Games turnaround thesis, the most important factor for Square Enix stock, and the key reason to own it, is the highly profitable (~60% margins) MMO segment. This segment contains the company’s crown jewel asset, Final Fantasy Online (FFO), arguably the most profitable video game forever franchise—and the highest-quality, since it monetizes via a $15 a month subscription fee, the rarest monetization model in gaming. In Q1 FY23, this segment reported a small decline in year-over-year net sales, which spooked some investors.

However, this decline should have been expected because of the content cycle for FFO, which creates variability in what is still a strong secular growth trend. FFO has two different cycles that overlay each other: 1) Content (major expansion and patches), which create outsized quarters and 2) Hype, which build momentum starting 3 to 4 quarters before a major expansion launch. This past Q1 FY23 came at the end of a Content cycle for Endwalker, and marked the beginning of the next Hype cycle for the Dawntrail expansion. This upcoming Hype cycle includes two fan fests and the upcoming 6.5 patch (broken up into two parts). When the end of a Content cycle coincides with the beginning of a Hype cycle, the result is often a “calm before the storm” quarter (Fig. 1).

Figure 1. MMO Segment is about to enter a new Hype Cycle (blue bars forecasted)

There is another reason not to extrapolate the MMO segment’s Q1 performance into the future. On July 28, 2023, at the FFO Fan Fest, the company announced that for the first time, FFO will soon be available on Xbox Series X consoles. Mr. Kiryu has personally led this initiative, because of the huge value accretion of every incremental user that is added to FFO. FFO will go live on Xbox Series X as an open beta as part of the 6.5 patch (expected in October 2023). This opens the door for FFO to a player base of +21m Series X consoles sold to date, and over time to the rest of the +80m Xbox ecosystem of users. This platform expansion will accelerate FFO’s usesr base growth and continue its leadership as the top MMO in the world.

To reiterate, we retain our high conviction in the original Square Enix investment thesis we first shared in the summer of 2021, which argued that the company’s world-class portfolio of forever franchises was being undervalued by temporary losses in the HD Games subsegment. And we retain our specific conviction that the company’s flagship Final Fantasy franchise is worth more than the company’s total enterprise value, giving investors the rest of its portfolio “for free.” Finally, we retain our conviction, which we developed and shared starting in March 2023, in the timing of the HD Games turnaround: the next 12 months will see an inflection for HD Games—and therefore for all of Square Enix and its valuation.

Catalyst

HD games turnaround in next 6 to 12 months