Description

Square Enix Thesis Update – HD Games Turnaround
March 27, 2023

In our original Square Enix investment thesis (published July 15, 2022), we highlighted the company's portfolio of forever franchises and argued that it was undervalued due to temporary losses in the company’s HD Games subsegment. We specifically noted that the Final Fantasy franchise was worth more than the company's total enterprise value and that the rest of the portfolio was “free.”

We remain confident in our overall thesis today. But for the first time, we now have conviction in the timing of the HD Games turnaround: The 12 months ending March 2024 will be the crucial year of inflection for HD Games—and therefore for all Square Enix and its valuation.

We believe this for three reasons:

1. The lossmaking factors that weighed on HD Games are now in the past and we don’t expect them to repeat in FY24e.
2. HD Games will release some very profitable games in FY24e.
3. Most importantly, the company will soon have a new younger and English-speaking president, Takashi Kiryu, who promises to shake up the company.

Square Enix retains its rich pipeline of new games from its core franchises, including Final Fantasy, which provide the company with numerous catalysts in the medium and longer term. In addition, we expect Kiryu to continue the formula that has worked so successfully for Final Fantasy Online, while making numerous changes throughout the rest of Square Enix.

However, we are confident he will focus his immediate efforts on the HD Games subsegment, that he is correct to do so, and that he will lead it to a sharp turnaround.

The past losses in HD Games for Square Enix are soon to be behind them. The disappointing new IP attempt, Forspoken, has already incurred losses which will be booked in the upcoming fourth quarter of the fiscal year ending March 2023. Looking ahead, the pipeline for FY24e is low-risk and heavily focused on new games from existing, widely popular, and financially successful internal IPs such as Final Fantasy.

While Square Enix has faced losses in the past due to underperforming franchises and new IP attempts, these losses should be considered separately from the company’s core internal franchises, such as Final Fantasy, Dragon Quest, and Kingdom Hearts, which have been incredibly profitable.

Furthermore, Square Enix has taken steps to rectify the lossmaking factors that have weighed on the subsegment by centralizing its resources and functions. They have already divested underperforming overseas studios, centralized their publishing function at their Tokyo headquarters, and folded underperforming Japanese studio Luminous Productions into their core internal teams.

Given these developments, the loss-making factors in HD Games are now in the past, and we have no expectation that they will repeat in the next 12 months.

The upcoming releases from Square Enix's HD Games subsegment, Final Fantasy 16 and Final Fantasy VII Rebirth, are expected to be highly profitable in FY24e. We believe that these games, both from the highly successful Final Fantasy franchise, will make significant contributions to the overall profitability of the company.

Our confidence in these games stems from the impressive development teams behind them, as well as their strong underlying intellectual property and their smooth development phases. In the case of FF16, which is in its prelaunch marketing phase, the game has received an overwhelmingly positive reception from previewers, giving us confidence to say the game will be a major profit contributor.

We anticipate that Final Fantasy 16 will attract a new generation of users and exceed market expectations by selling at least 8 million units in its first year and achieving lifetime sales of over $1 billion or 15 million units. Because of this, we estimate total group operating profit of $732 million, a number that is +45% above consensus estimates. We think consensus estimates assume zero operating profits from Square Enix’s HD Games subsegment (vs. our estimate of a 30% EBIT margin). Because we already assume FF16 will exceed its development cost and marketing launch budget, in our base estimates we expect incremental $343 million in operating profit if FF16 reaches our bull case estimate of shipping 15 million units its first year (an incremental 7 million units at $70/unit less 30% platform fee). This would put operating profit at +113% above consensus (Fig 1).

Fig 1. Final Fantasy 16 can deliver blow-out earnings vs. consensus expectations 

Additionally, Final Fantasy VII Rebirth benefits from an established and devoted fan base, with the sequel to Final Fantasy VII Remake expected to continue its winning streak. The combined success of Final Fantasy 16 and Final Fantasy VII Rebirth will drive a sharp pivot in operating profit in the HD Games subsegment, leading to a huge turnaround in profitability starting in FY24e (Fig 2).

Figure 2. HD Games will see a huge turnaround in profitability starting in FY24e.

The imminent appointment of Takashi Kiryu as the new President of Square Enix is the biggest upcoming catalyst for the company, offering investors a genuine opportunity for change. We believe that Kiryu's appointment represents a departure from traditional Japanese business practices, as he approaches his role with a mindset more akin to that of a Western investor.

Kiryu is only 47 years old and is an English-speaking MIT Sloan Fellows MBA graduate. Kiryu will have responsibility for all Square Enix, and we are broadly optimistic about his plans for the company as a whole. However, we believe his most immediate area of focus, and our area of maximum optimism, is the HD Games subsegment.

We believe that in his previous role as Chief Strategy Officer, Kiryu acted as the driving internal force behind the bold steps taken to transform Square Enix's HD Games business. His systematic approach involved removing all the loss-making factors that have weighed on HD Games and centralizing the company’s development resources and publishing functions. Kiryu is implementing a "reset and build" strategy and we believe we are at the cusp of the “build” part, which will produce a sharp turnaround in HD Games.

At the center of Kiryu’s strategy is the idea of “going back to the basics” or focusing on “first-principles.” In video gaming this means focusing on “fun” games. We believe Kiryu is laser-focused on creating high-quality, “fun” games rather than prioritizing Square Enix’s long-held belief that providing the “the best graphics” should be at the forefront of video game making. We believe this is an important philosophical change happening at the business.

In order to prioritize fun, we know that Kiryu has been scrutinizing Square Enix’s existing development processes, and spending much of his time speaking to the various studios and key people at Square Enix. Instead of a pure "product-out" approach, we believe Kiryu will lead the charge in developing more "consumer-in" processes, ensuring that gamers are at the heart of everything Square Enix does. Kiryu recognizes the need for a change in approach after years of HD Game development that didn't always consider what gamers wanted. Since many developers have worked at Square Enix for decades, we think Kiryu recognizes the need to “shake-up” the deeply ingrained notions and perceptions that have led to a “product-out” strategy at HD Games.  

To achieve this goal, we believe Kiryu is developing new organizational structures that encourage a more collaborative approach between teams, departments, and studios. By breaking down long-held silos and fostering a more integrated environment, Square Enix can achieve greater information, idea, and technology sharing, resulting in higher-quality games and better financial performance in the HD Games subsegment. Having spoken with several experts of Japan’s video game industry and ex-employees of Square Enix, we have primarily knowledge that suggests the siloed environment that HD Games has worked under has greatly hindered the potential of the business. Square Enix has some of the industry’s best and most highly respected video games creators, directors, and producers, and we think that breaking the silos could unlock tremendous value for the business.

With a focus on delivering a better game cadence in Square Enix’s core internal franchise series, Kiryu is poised to see HD Games release highly anticipated new entries in their popular game franchises such as Final Fantasy, Dragon Quest, and Kingdom Hearts. Additionally, we believe Kiryu will usher in an era of remakes and remasters of previous widely popular entries from Square Enix’s core franchises. This will further boost game cadence and considering the financial success of the FF7 Remake series, it offers a predictable way for Kiryu to improve HD Games’ operating profit margins.

Finally, to signal to the market that there is a new HD Games and therefore a new Square Enix, we believe Kiryu will greatly improve the company’s disclosures, and will focus investor relations efforts on better telling the story of the turnaround at HD Games. We are already in contact with the company and are set to meet with Kiryu to share our own thoughts and specific suggestions on this subject. We believe the narrative around the investment case for Square Enix should greatly improve in the months to come and expect the future under Kiryu's leadership to be bright.

We believe that Square Enix's HD Games subsegment will undergo a turnaround led by the upcoming new president Takashi Kiryu, and that this turnaround will finally shine a light on the quality and underlying attractive economics of Square Enix’s core forever franchises. The 12 months ending March 2024 will see the crucial inflection of HD Games—and therefore for all Square Enix and its valuation.

Despite this imminent turnaround, the continued robust performance of Final Fantasy Online, and all the value-unlocking changes that have already happened, the stock price of Square Enix has remained relatively flat. We therefore believe now is the perfect time to invest in or add to Square Enix.

Based on our non-consensus EBIT estimates, we believe that assuming a base case of $512 million in FY24 NOPAT ($732 million EBIT), the stock could revalue by +78% to JPY11,164 per share (we assume a peer average multiple of 20x NTM EPS). In our bull case, where we estimate NOPAT of $735 million and use the same multiple, we estimate the stock could more than double to JPY16,396 (+161%) (Fig 4).

Figure 4. Square Enix has multiple catalysts ahead to drive value over the next 12 months.

Catalyst

1. Recent CEO change

2. Upcoming pipeline