Description

Summary

Square Enix is a well-positioned video game publisher in Japan. The company has created several globally recognized brands (Final Fantasy, Tomb Raider, and Kingdom Hearts) that have experienced multiple decades of staying power and have continued to adapt and innovate as the gaming landscape has changed. Like EA and its sports games, or Disney and its super hero movies, Square can continually tap into its IP library to release titles that are familiar and loved by millions of gamers around the world.

Square has a defensive net cash position (~25% of its market cap), and trades at a very reasonable ~9.5x FY 2020 EBIT (ending March 31). Square’s founder and honorary chairperson of the board owns ~25% of the shares outstanding. The company is a prudent (although conservative) capital allocator; they repurchased ~2.5% of the stock outstanding within the last year and maintain a 30% dividend payout ratio.

Business Overview:

The company has three main video game segments; HD games (for PlayStation or Xbox), games for Smart Devices / PC (apps for mobile) and Massively Multiplayer Online (MMO) games (subscription online games that feature many simultaneous players).

HD Games:

Within its HD game segment, Square excels in the role-playing game (RPG) genre. Square Enix has created the world’s most popular RPG, Final Fantasy. The franchise was established over 30 years ago and has a devout fan base worldwide. Final Fantasy has set the record for most RPG titles (87) with cumulative game sales >135mm copies.

The company has continually adapted to new technologies, consoles and gamer preferences to create a consistent, top tier offering. The last iteration of Final Fantasy was released in 2016 with the next iteration expected around FY2021.

Other Square HD game titles include, Dragon Quest, Tomb Raider, and Kingdom Hearts.

Square’s HD business now accounts for ~34% of its game sales (down from 62% in 2013) as it’s grown less quickly relative to the company’s mobile business. Square earned a ~9% operating margins on its HD segment in FY2018. Square’s HD business is stable and should compound at low to mid single digits that will experience periods of outperformance with big title releases.

This segment could experience significant upside optionality if Square increases its digital download mix and monetizes its games through micro transactions or downloadable expansion packs (discussed further in investment highlights).

Smart Devices / PC:

Square has leveraged its strong IP library to build an impressive mobile business. Square has both vastly increased the engagement and size of its target market by releasing mobile iterations of its Final Fantasy and Dragon Quest franchises.

Square’s mobile business has grown at an impressive 33% CAGR from FY2013 to FY2018, growing 13% in the last year. Mobile as a category is experiencing healthy growth as the install base of phones is much larger than any console and gamers typically pay for engagement. Square’s mobile business could grow high single digits to low double digits for the next several years.

The company’s mobile business now accounts for ~50% of the total digital entertainment segment. Square earned ~20% operating margins on this business in FY 2018.

MMO:

Square’s MMO business is the smallest (~17% of digital entertainment sales in FY2018), but is sticky and recurring. Square earns revenue from the upfront sale of its software but also earns monthly service fees for providing an online platform for gamers.

Square’s MMO business has grown nicely at a 23% CAGR over the last 5 years. Because of the monthly service fee dynamic, the MMO business earns significantly higher margins relative to its HD segment at ~14% in FY2018.

Other:

The company also manages arcade centers and sells game related books, comics, and merchandise. This side of the business has become less meaningful as digital growth has outpaced it. Square’s “other” business now only accounts for 13% of EBIT. This earnings stream is stable, contributing an average of $58bn in revenue from 2013 to 2018 (high $60bn, low $55bn) with an average of $7bn in EBIT (high $8bn, low $3bn).

Investment Highlights:

Video Game Industry is Attractive:

Over the last several years, global video game publishers have been significant beneficiaries of margin expansion. For example, EA has experienced EBITDA margin expansion of 2400 bps over the last 5 years.

The margin expansion is primarily attributed to two things: firstly, games are more commonly digitally downloaded; this is higher margin as publishers don’t have to share profit dollars with retailers, and allows for easier inventory management (digitally downloaded games are ~25% higher gross margin).

Secondly, the industry has pivoted to issuing fewer games per year with longer game longevity. Similar to movie studios, publishers are taking fewer risks on fewer titles and are instead sticking to franchises that resonate with gamers. Publishers are supplementing game sales with add on content and cosmetic character costumes (called skins); both of these new revenue streams are very high margin.

HD Games has High Upside Optionality:

While other industry participants have been quicker to capitalize on the favorable tailwinds mentioned above, Square is still in early innings of this transition.

Square is currently benefiting from the mix shift to download games although so far this has mostly been felt within its U.S. business. The company’s domestic business has experienced this shift more slowly. Currently ~50% of Square’s video games are downloaded digitally, over the longer-term we would estimate this increases closer to ~70-80%.

Secondly, and potentially more importantly, Square has yet to introduce micro transactions or downloadable content in a meaningful way. Square should have ample opportunity to do this as ~50% of the company’s customer base is located in the U.S., where gamers are both receptive and interested in this revenue model.

Exposure to Fast Growing (and Higher Margin) Mobile Segment:

As discussed, Square’s mobile business has experienced extremely strong growth. Given gamers can play virtually anywhere, at any time, and don’t need to purchase an expensive gaming console, the gamer universe is multiples larger than any other platform. Mobile gaming is expected to grow at a very healthy clip, as the industry is still young and maturing.

The mobile business is also monetized differently, rather than paying for a game up front, users typically pay more the longer they’re engaged. The mobile monetization model has resulted in operating margins that are 2x higher than Square’s HD business.

Deep Library of IP that Reduces “Hit Risk”:

Square’s history and IP library allow it to introduce sequel games that are less risky relative to brand new titles. Square can also use its IP across the various revenue streams. For example, being able to break into the mobile category with a Final Fantasy launch is a huge competitive advantage relative to unestablished game developers. Square has recently announced it’s planning to relaunch older Final Fantasy titles, which should be much higher margin relative to new titles.

Attractive Valuation with Strong Balance Sheet:

Square trades at a reasonable multiple of ~9.5x FY 2020 consensus EBIT, relative to EA at ~18x and Activision at ~17x. This is particularly noteworthy as we also believe Square could have much greater margin expansion potential.

Good Capital Allocation and Governance:

Square has established a reputation of being a prudent capital allocator. The company pays a solid 30% dividend and has recently begun to repurchase shares. While we would probably prefer the company to be more aggressive in its repurchases and run with a smaller net cash position, we prefer a conservative management team to an aggressive one.

Risks:

Overspending / Production Delays:

Anecdotally, it seems like the company can occasionally run into some production delays, at this year’s E3 event some fans were bothered that popular titles weren’t given concrete release dates.

New Titles May Be Unsuccessful:

Given Square relies on a few marquee franchises it’s important that these games generally live up to expectations. A colossal miss on the next Final Fantasy for example could weaken the brand given there is usually several years between releases.

Lack of “Staying Power” in Mobile:

While it’s incredibly impressive to see what Square has managed to do with its mobile business in a relatively short period, it’s also somewhat unnerving. On one hand, the company has successfully leveraged its IP to gain a strong foothold that should give it a competitive advantage relative to brand new titles with brand new IP. On the other, mobile is still a new category for distribution that could see industry wide changes.

Important Disclaimer:  This report does not constitute a recommendation to buy or sell the security discussed herein.  The report is an example of the author’s company write-ups / research process; its breadth and coverage may differ materially from other such reports.  Certain statements reflect the opinions of the author as of the date written, are forward-looking and/or based on current expectations, projections, and/or information currently available.  The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term.  The views are those of the author acting in his individual capacity and not as a representative of any firm; in no way does this report constitute investment advice on behalf of any such firm

Catalyst

DLC / Micro Transaction roll out

Final Fantasy 7 remake release date

Continued mobile success