Description

Square Enix Summary Thesis

Square Enix ($4.2 billion enterprise value) is a leading Japanese video game company that owns a rich portfolio of “forever franchises” in video games. Forever franchises exhibit industry-leading user engagement metrics, are social/multiplayer experiences, and show resilience against competition. This translates into video games that are long-lived and will grow over long-term horizons, with the best becoming niche social networks. Square Enix's forever franchises include Final Fantasy (34 years old), Dragon Quest (35 years old), Just Cause (15 years old), Space Invaders (43 years old), and Kingdom Hearts (19 years old).

We believe the value of this portfolio is currently being overshadowed by temporary and misunderstood losses within the HD Games subsegment of the company’s Digital Entertainment segment. Because of this, Square Enix's crown jewel, Final Fantasy, is now by itself worth well more than the total enterprise value of all Square Enix, thus allowing us to own the rest of the company's portfolio of IPs and assets "for free." We believe Square Enix today offers a 3x upside to reach our current intrinsic value estimate of $12.7B enterprise value (Final Fantasy ~US$7.6B and the rest of Square Enix ~$5.1B) (Fig. 1). 

Figure 1. Square Enix is deeply mispriced today

The first and most critical assumption of our Square Enix investment thesis is that the company’s Final Fantasy franchise warrants a premium valuation due to the quality of the asset.

A little background: Final Fantasy is a Japanese anthology fantasy media franchise created in 1987 by Hironobu Sakaguchi. The 34-year-old transmedia IP spans a video game series with 15 main titles, 163m+ units sold, multiple spin-off titles, merchandising, film, and comics. Final Fantasy is one of the most recognizable brands in video gaming and has cumulatively generated $16B in revenue, making it one of the highest-grossing video game franchises in terms of life-to-date revenue.

The franchise’s massively multiplayer online (MMO) game, called Final Fantasy Online, is its crown jewel. Final Fantasy Online has won multiple accolades during its +10-year journey, and within the last 6 months it has won game industry awards for “Best Community”, “Best Ongoing Game”, “Game of Year”, and “Best MMORPG”. Final Fantasy Online beat out well-known industry rivals such as Fortnite (Epic Games), Apex Legends (EA), Call of Duty (Activision), and Genshin Impact (miHoYo) to win several gaming awards. Unlike any of these games, Final Fantasy Online is designed to be played for the rest of your life—and it’s by far the deepest-engaging virtual world (Fig. 2).

Figure 2. Players often get married in the game via an “Eternal Bonding” system

Final Fantasy Online monetizes primarily via the rarest and highest-quality business model in gaming: a monthly subscription fee of $15. The subscription model is practically unseen today in video game monetization, accounting for only 1% of total industry revenues in a landscape that is now dominated by free-to-play games (Fig. 3). 

Figure 3. Final Fantasy Online monetizes primarily via subscription, the rarest and highest-quality business model in video games

During our analysis of the prototypical Final Fantasy Online player, we learned that the average player has been a paying monthly subscriber for ~5 years. This means that compared to traditional AAA-quality buy-to-play games, which typically retail at $60, the lifetime value of a Final Fantasy Online player is 15x more (Fig. 4). We also learned that Fantasy Online players exhibit extraordinarily high engagement with an estimated +40% of the player base spending +20 hours a week in the game (Fig. 5). 

Figure 4. Final Fantasy Online players are worth materially more than other games

Figure 5. Final Fantasy Online is an extension of players’ identities

A unique attribute of the game is the massive amount of content that Final Fantasy Online offers. As each expansion builds on previous ones, the game continues to grow its cumulative content which can now take over 1,500 hours to complete a full playthrough of “single-player” story content with co-op content at over 1,400 hours. We believe this acts as a barrier to entry and widens the moat against new MMO competitors. 

Unlike most games which experience a boom-bust-cycle, or lose popularity over time, Final Fantasy Online has continued to deliver better and more engaging content with each expansion, growing its subscriber base significantly over its lifetime. Their latest expansion, Endwalker which released December 7, 2021, was Final Fantasy Online’s biggest expansion to date and saw record high subscribers. Critical reception for the expansion was the highest in the game’s history with a Metacritic score of 92 vs. previous expansions in chronological order, A Realm Reborn/Heavensward/Stormblood/Shadowbringers scoring 83/86/87/91, respectively. Following its expansion, peak concurrent players on Steam reached an all-time high and the game attracted so many players that Square Enix had to suspend new base package sales to help alleviate server congestion. 

Based on our tracking of census estimates and applying our own adjustments, we estimate that Final Fantasy Online paying subscriber base is +1.4m today (Fig. 6). Final Fantasy Online is in the middle of a growth inflection point. Final Fantasy Online has seen an influx of users in 2021 and Square Enix is committed to reinvesting in expanding the +10-year-old game. In addition to continuous content updates and major expansions (released every two years), Square Enix is doing a full graphics overhaul of the game which will include all the previous expansions, the earliest of which have seen their graphics age with time. Square Enix expects the graphics overhaul to be fully rolled out by patch 7.0 (the next major expansion, which will likely release at the end of 2023). Square Enix also plans to make the game fully playable solo - with Final Fantasy Online having one of the best stories in the Final Fantasy series, we think this will attract a lot of Final Fantasy fans to the game that typically don’t play MMOs. Given much of the endgame content and MMO features of the game are not all hardcore high stakes gameplay but in fact much of it is passive/social activities, and since the community is famously welcoming to new players and overwhelmingly positive, we also think there is a good chance that some of these players will go on to try some of the MMO features of the game and stay on as subscribers. 

Figure 6. Final Fantasy Online expansions have driven subscriber growth

While Final Fantasy Online is the most successful part of the Final Fantasy franchise, remember that Final Fantasy is a transmedia IP. Final Fantasy Online is just one game out of many Final Fantasy game titles, with 5 additional titles having sold +10 million units each. Moreover, the series has spawned many mobile games and spin-off franchises such as Kingdom Hearts, a crossover between Final Fantasy characters and Disney characters, which has sold over 32 million units worldwide. The franchise has also produced a movie and comic, and today still generates meaningful revenue from merchandise sales (we estimate ~$50M run rate). The ability to successfully monetize a deeply engaged user base across multiple media beyond gaming is an achievement only half of the top IPs in video games today can claim. Interestingly, these transmedia IPs are all owned by Japanese video game companies (Fig. 7). 

Figure 7. Final Fantasy is one of the top Video Games IPs of all time

Final Fantasy, like Pokémon and Mario, has had a profound impact on popular culture. For many consumers in the West, it was their first introduction to Japanese RPGs and became a key reason to buy a PlayStation at the time. It set the standard and became the most common art style for Japanese RPGs going forward and was the first to introduce a dramatic storyline with a strong emphasis on character development and personal relationships. The series also inspired many of the most successful game designers today, who consider it a “genre-defining game.”

When we look at it holistically, we believe the Final Fantasy franchise as a standalone asset is worth ~US$7.6B enterprise value, or +81% more than Square Enix’s enterprise value today (Fig. 8). 

Figure 8. Breaking down the Final Fantasy franchise by its revenue stream quality

To arrive at this valuation, we broke down the franchise’s revenue streams by their quality using Square Enix’s reporting structure as our base framework. 

Most of our intrinsic value estimate comes from the Final Fantasy Online title, where we estimate normalized margins are +55%. While this may appear high, the MMO subsegment, of which Final Fantasy Online is a large part, reported a 50% operating margin in FY21 (see the next section for a description of Square Enix’s segment and subsegment reporting structure) and based on discussion with management we think it reached +60% in FY22 (Square Enix no longer reports operating profit at the subsegment level). We believe this could be even higher in the long run, as it does not consider the untapped pricing power of Final Fantasy Online, whose subscription fee has remained a flat $15 a month for 10 years now. Due to the rare stability of its subscription revenue, its high value user base, and its resiliency against competition, we attach a 20x multiple on $304M 2023 operating profit for a $6.07B enterprise value.

Our HD Games estimates includes the release of Final Fantasy XVI, which we estimate will release in June-2023 and sell +8M copies within its first year, generating $560M in gross revenue ($70 average selling price), or net revenue of $392M (after 30% platform fee). We expect the remainder of net revenue to come from catalogue sales. We expect that the HD Games component of Final Fantasy will generate a 20% operating margin and attach a 13x EV/EBIT multiple on our 2023 EBIT estimate of $81M (closest Japanese HD Game peer, Capcom, trades at 13x) for an enterprise value of $1.06B. 

In the Game for Smart Devices / PC Browser segment for Final Fantasy, we expect 2023 sales to reach $249M with a 16% operating profit margin (the same as our estimated FY21 aggregate subsegment margin) and attach a 12x EV/EBIT multiple (closest Japanese comps DeNA and Konami trade at 11x and 8x, respectively), for an enterprise value of $478M.  

In sum, through our strategic approach to valuing the Final Fantasy franchise, we believe we’ve uncovered a deeply mispriced, high-quality asset that gives us both a wide margin of safety and the upside of a compounding growth story.

Our second key assumption is that the market misunderstands the temporary losses within the HD Games subsegment, which are overshadowing the rest of Square Enix.

Square Enix's overarching strategy is to create and grow transmedia IPs by originating content and then monetizing it across multiple media formats. Square Enix operates across four business segments, each focusing on a specific media format: Digital Entertainment (video games), Publication (comics and books), Amusement (arcades and game machines), and Merchandising (figurines and toys).

The Digital Entertainment segment is by far the most important, representing 76% of group revenue. The Digital Entertainment segment itself comprises three subsegments, organized by video game type:

• HD Games (high-definition premium games for PC and Console)

• Games for Smart Devices / PC Browser (primarily free-to-play mobile games)

• MMO (massively multiplayer online games)

The latter two of these subsegments are profitable, with operating margins expanding in recent years. Together with the overall good performance of the non-Digital Entertainment segments, they point to a rational management team that generally makes intelligent capital allocation decisions (Fig. 9). 

Figure 9. HD Games has been a major detractor from group level margins

The issue is the HD Games subsegment of Digital Entertainment, which has volatile revenues and harder-to-predict earnings. In the last three years, Square Enix's HD Games subsegment has generated a loss, overshadowing the rest of Square Enix due to multiple HD Games title launches that “failed to meet expectations” (note that Square Enix no longer disclose operating profit margins at the subsegment level, and it is our estimate that they made another loss for this latest fiscal year ending March 2022). 

We think the market has interpreted the underperformance of the HD Games subsegment as being structurally related to all Square Enix’s HD games franchises and thus extrapolated this past trend. However, we believe the underperformance is due to the company’s failed attempts at expanding in western markets through its western studios, and that its core internal IPs (Final Fantasy, Dragon Quest, and Kingdom Hearts) are profitable. 

Over the last decade there have been several big-budget games that “failed to meet expectations”. Below we list out these games and the development studios behind them: 

Sleeping Dogs (Aug-2012) - Square Enix Europe

Tomb Raider (Mar-2013) - Crystal Dynamics (previously a western subsidiary)

Hitman (Mar-2016) - IO Interactive (previously a western subsidiary)

Dues Ex Mankind Divided (Aug-2016) - Eidos-Montreal (previously a western subsidiary)

Marvel Avengers (Sep-2020) - Crystal Dynamics (previously a western subsidiary)

Marvel Guardians of the Galaxy (Oct-2021) - Eidos-Montreal (previously a western subsidiary)

Outriders (Apr-2021) - People Can Fly (western studio, work-for-hire) 

Instead of trying to grow in western markets through its already successful Japanese IPs (Final Fantasy, Dragon Quest, and Kingdom Hearts) or new games developed by their domestic studios, Square Enix felt it needed to grow in western markets through “western IPs” and by giving autonomy to western studios (Eidos Montreal and Crystal Dynamics, specifically). In a move away from this strategy, Square Enix recently disclosed that they are selling Eidos Montreal and Crystal Dynamics, along with the Tomb Raider, Deus Ex, Thief and Legacy of Kain IPs. 

Since the announcement to sell its western studios, Square Enix has communicated that they will focus on reinforcing and investing in their “core” business, which we interpret as their original forever franchises (Final Fantasy, Dragon Quest, and Kingdom Hearts). These are already hugely profitable franchises for the company with existing core audiences and multiple successful games in their catalog. We view new game releases based on these franchises as being lower risk asymmetric bets. 

Furthermore, Square Enix announced that they plan to align their overseas publishing arm with their Tokyo office. One of the issues with Square Enix’s previous overseas expansion strategy was having two separate publishing (and management) arms, one at its Tokyo headquarters and another for its western studios. We believe the development and management style of these teams did not align with the corporate culture and development process of the Tokyo office and the lack of closer oversight by head office produced unintended results. By centralizing its publishing and IP management function at its headquarters, we think this will lead to overall better development oversight, cost management, and global publishing of new IPs as well as its existing core IPs. 

It’s clear that Square Enix sees the global potential of its core IPs and given the recent growth we’ve been seeing of Final Fantasy in the global market and early signs of growing global reception of Dragon Quest, we agree. But Square Enix won’t only focus on its existing forever franchises. The company will continue to create new IPs, primarily internally or through new domestic studios they are considering setting up. Although creating new IP is risky, we think it is crucial since developing a new major franchise offers years of earnings potential that far outweigh the costs of short-term misses. However, we think Square Enix is going to better balance new IP risk by centralizing resources on primarily new games from its successful forever franchises with fewer but bigger new IP bets. 

Square Enix’s pipeline has great potential of producing hit games, not only with high initial sales but with the potential that some of these games will turn into long-term sellers, driving future high margin catalogue sales. We see five important games in the pipeline: Final Fantasy XVI, Final Fantasy VII Rebirth (previously “Remake Part II”), Dragon Quest XII, Kingdom Hearts IV and Forspoken (a new IP). We expect all these franchises to reach cumulative unit sales figures higher than their predecessors with a new-gen console cycle as a tailwind. Further, all these games are targeting both Japanese and western gamers (see the appendix at the end of this investment memo for more detailed product descriptions). In addition to the above internally developed blockbuster games, Square Enix is also working on a few mid-budget (low risk) games including, Star Ocean Divine Force, The DioField Chronicle and Valkyrie Elysium for 2022.

While some previous main games in Square Enix’s core franchises have seen a rough development process with changing directors, engines, etc., we have observed so far, a rather smooth development process to Square Enix’s upcoming games. 

What we have laid out above is a strategic shift in the companies HD Games business toward more internally developed original IP games which we believe have blockbuster-potential with limited downside risk given their existing core audiences and past successes. Since this segment is largely driven by pipeline, many may be asking the questions of what this segment will look like after the release of these games, and while it’s hard to predict that far out we see Square Enix’s new strategy as a long term one where new games from their major franchise could see a more frequent release cadence. For illustrative purposes, their biggest franchise, Final Fantasy, has roughly a two-to-three-year launch cycle but Square Enix has also created a new remake series of their famous Final Fantasy VII entry and may continue to make remakes of previously success entries from the late 90s and early 2000s (a so far accurate Nvidia leak suggests a remake to Final Fantasy IX), which when layered next to each other and in conjunction with upcoming releases to its other forever franchises like Dragon Quest and Kingdom Hearts, could lead to overall better long-term margins and a more smoothed out earnings stream. 

Moreso, we see further potential upside to long-term margins should these new main games turn out to be timeless high-quality new-gen titles in the series, where the games quality and the tailwind of a growing new-gen console install base could lead to material long-term improvement in the HD Games margins as these newly released titles potentially turn into long-term catalog (long-tail) sellers (costs are amortized within 3 months of a game’s launch and thus margins for catalog sales are virtually 100%). A growing mix of catalog sales is one of the surest ways of generating margin expansion in the HD Games business, and a good comp is Capcom which grew its operating margins from 16% in their fiscal year ending March 2017 to 39% March 2022, primarily on the back of an expanding catalog sales mix. Not only would this lead to improved HD Games subsegment margins but it would significantly mitigate pipeline risk in the subsegment, since earnings from catalog sales can absorb the initial costs of big-budget releases. 

Beyond simply the direct P&L impact of the HD Games subsegment, is the strategic importance of the subsegment in Square Enix’s overarching business model of originating and monetizing transmedia IPs. Importantly, the HD Games subsegment is where Square Enix has originated most of its major IPs. It is here where the highest-production-value AAA games are produced, which can cost more than +$100m and take anywhere from 2 to 5 years to develop. Said differently, HD Games is where Square Enix’s takes “shots on goal” and invests in “research and development,” so investors should think about this subsegment strategically. If Square Enix invests more into new IP development, then there is a higher risk that losses in HD Games can overshadow the true unit economics of the rest of the group, but these losses should be transitory. The short-term losses associated with some new IP bets pale in comparison to the subsegment’s overall role in creating Square Enix’s next “forever franchise.”

Overall, we view Square Enix’s Digital Entertainment segment as synergistic, with most of the company’s IP eventually generating revenues across all three subsegments. This synergy will help make Square Enix one of the next great transmedia IP companies. But this process starts with winning the video game medium, and this first takes place in the HD Games subsegment. A rational stock market would ascribe significant positive value to this subsegment, rather than the significant negative value being ascribed to it today.

Our last key assumption is we are getting a portfolio of IPs, a promising game pipeline, and other strategic business units for “free.” We believe this is worth an additional $5.1B.

If we exclude Final Fantasy from Square Enix, that leaves us with ~$2B in revenue across multiple IPs, the biggest of which is Dragon Quest, and three non-gaming business segments (Fig. 10). 

Figure 10. Square Enix Revenue Mix excluding Final Fantasy

Square Enix has multiple IPs, with some that generate more recurring revenue streams and others more sporadically based on their content cycle. Some of Square Enix’s major IPs include Space Invaders (+3.8B lifetime revenue), Dragon Quest (+81 million units sold), Kingdom Hearts (+32 million units sold) and Just Cause (+15 million units sold).

The most notable of these is Dragon Quest, which is the 2nd most profitable franchise after Final Fantasy and is the highest grossing IP in Square Enix’s Games for Smart Devices / PC Browser (or Mobile) subsegment. The franchise consists of a series of role-playing video games that include 11 mainline entries, an MMO, and several mobile games, the most successful of which is Dragon Quest Walk. Despite Dragon Quest being 35 years old, the franchise continues to grow. Dragon Quest revenue grew at a 33% CAGR between FY19 and FY22, driven mainly by growth in mobile, where Dragon Quest Walk grossed over $330M in CY2021. Dragon Quest Walk is an augmented reality role-playing game that shares similarities to Pokémon Go. In Japan, the game ranked as the 9th highest-grossing mobile game of 2021, just shy of Pokémon Go, ranked number 8 and generating $345M. 

Square Enix has been more frequently communicating its plans to develop more mobile games inhouse. Historically speaking, Square Enix’s mobile games have primarily been developed by external studios where Square Enix has taken on only a publishing role. Internally developed, self-published games could generate 21-28% higher operating margins (we estimate FY22 EBIT margins of 16% in the subsegment) than pure publishing deals since developers typically share between 30-40% of net revenues (after 30% fee charged by Apple and Google), with publishers typically taking the remanding 60-70% share. Overtime, it’s likely that Square Enix’s Games for Smart Devices / PC Browser subsegment evolves to reflect more revenue from new games rather than existing catalog titles, and to the extent that most of these new games are internally developed, we think there is room for material margin improvement in the Games for Smart Devices / PC Browser subsegment. 

~24% of Square Enix’s group revenue comes from its three non-Digital Entertainment segments: Publication, Merchandising, and Amusement. The most interesting is the Publication segment, which accounted for 8% of group revenue and 21% of Group operating profit in FY22. The Publication segment deals with the publishing and licensing of comic magazines, comic books, and game-related books. Products in this segment include Shonen Gangan, Manga UP!, Gangan Online, Ultimania Series, Soul Eater, and Fullmetal Alchemist. Fullmetal Alchemist is the segment’s most successful comic with over 64 million volumes sold worldwide. The segment has grown at a 27% CAGR between FY19 and FY22, driven mainly by digital sales, and has seen its operating profit margins expand from 28% in FY19 to 42% in FY22.

In valuing the rest of Square Enix, we estimate revenue and operating margins for its second biggest IP Dragon Quest and estimate revenue and operating profits for the rest of Digital Entertainment by netting out Final Fantasy and Dragon Quest. For its three other segments we use reported revenue and operating profits and apply average multiples based on industry comps (Fig. 11). 

Figure 11. Intrinsic Value of the Rest of Square Enix

Lastly, Square Enix has a pipeline of new IPs that have been in development for many years, with some nearing their completion. The most notable new IP is Forespoken which has received strong reviews (+5m views on YouTube) and will release on PS5 in Jan-2023. Predicting pipeline isn’t our task, but we do estimate that Square Enix’s pipeline of new IPs has the potential to add an additional $2.5B in cumulative revenues over the next few years. To arrive at this number, we take Square Enix’s content production account, which stands at $2.1B and represents the cumulative development costs of games in their pipeline (both new IPs and new games from existing IPs) and assume that 30% (or $630M) of the content production account represents investment in new IPs. We assume that the average development cost as a percent of revenue is 25% and thus the cumulative revenue potential is 4x (1/25%) the investment, or $2.5B. Because the potential earnings power of new IP doesn't show up in current operating metrics and has no basis to measure existing demand (e.g., unit sales of previous entries to existing franchises), there is inherent uncertainty of success. We thus assume a conservative 20% hit rate of success producing $500M in expected cumulative revenue from new IP which we could value at 2x revenue, thus new IP could potentially add an additional $1B in value that would accrue above our current intrinsic value estimate which we’ve derived from Square Enix’s existing forever franchises. 

Square Enix offers multiple ways to win: The crown jewel, Final Fantasy, is worth more than the entire group’s current market value, there is a margin expansion story on the back of HD Games’ normalization in the next few years and Games for Smart Devices / PC Browser vertical integration. 

Today, Square Enix's valuation is at the bottom of its peers. We believe this is mainly due to its lower headline operating profit margins, which have been weighed down by the HD Games subsegment's recent losses discussed earlier. Furthermore, we believe the market is penalizing this subsegment because of its volatile revenue and earnings profile, rather than viewing it as a strategic unit for originating new IPs. As a result, the current narrative surrounding Square Enix is something like “Square Enix is basically just Final Fantasy, and Final Fantasy is basically just another video game IP.”

However, we think the next few years can produce a very different narrative. Square Enix can materially surprise with +21% EBIT CAGR (’22 – ’24) on the back of Final Fantasy Online’s growth inflection (we think Final Fantasy Online could reach +3.5M subscribers by FY2026) and the normalization of the HD Games subsegment’s profitability (we think at least +12% EBIT margins). Accordingly, we think Square Enix should trade at a much higher EV/NOPAT multiple (Fig. 12). 

Figure 12. The market doesn’t price in the earnings growth we see coming from Square Enix’s forever franchises, esp. Final Fantasy

Another way to value Square Enix is on an EV/Revenues basis. Today, the market attaches little value to its revenues, as the company is trading at 1.6x revenue. This makes it one of the cheapest AAA video game companies in the world. There is a clear correlation between game companies reporting higher operating margins and the market revaluing them on a higher revenue multiple. Within the next few years, we think 20-30% EBITDA margins for Square Enix are reasonable to achieve. If we assume Square Enix reaches an operating profit margin of 25% (the mid-point of the range we’re assuming), we think a 3.6x EV/Revenue multiple would be fair. We estimate Square Enix could see its total revenue CAGR at 17% reaching $5.1B, that will give an enterprise value by FY26 of $18.4B or a 44% IRR from today’s enterprise value of $4.2B (Fig. 13). 

Figure 13. Today Square Enix is one of the cheapest AAA video game companies despite its potential to achieve 20-30% long-term EBIT margins. 

To summarize, Square Enix's valuation today (~$4.2B) pays an investor to take risk with a wide margin of safety, because the standalone value of the Final Fantasy franchise is easily worth more than the group’s market value today. At ~1.6x revenue, the market implies Square Enix is a structurally low-margin video game company and ascribes little to no value to the rest of its portfolio of IPs. We thoughtfully disagree with this conclusion due to our extensive analysis of Final Fantasy’s quality. By shining a light on the underperformance of the HD Games subsegment, we believe that it is temporary and should be viewed with more nuance because of its ability to create valuable new IP over time as supported by its track record of success (Fig. 14).

Figure 14. Square Enix is deeply mispriced today

Our conviction comes from breaking down Square Enix by its IPs, which led us to uncover Final Fantasy’s success as both a transmedia IP and a forever franchise. The Final Fantasy Online title is the franchise’s crown jewel, a title that drives material amounts of earnings from a monthly subscription fee–the rarest form of monetization in games today. Final Fantasy Online has one of the most dedicated fan bases in gaming and is a true example of a "metaverse" when it comes to the merging of one’s identity across virtual and non-virtual worlds. Simply put, the fundamentals point to us owning the #1 virtual world today, but the company’s valuation implies the market hasn’t figured this out yet.

What are the risks and concerns we have?

• There is a margin expansion story implied in our analysis. We can be wrong here in the near-term as Square Enix continues to invest in big AAA HD Game projects, which may show no success, and their losses may overshadow Square Enix’s successful IPs like Final Fantasy. However, since Square Enix’s pipeline in its HD Games subsegment is more skewed to games based on its existing forever franchises, this risk is much lower now than in previous periods. 

• Square Enix has a considerable "unallocated expense" line item explained as corporate overhead and consulting expenses. We have been prudent in our approach by estimating that this grows with revenue. However, we may have underestimated this line item which could weigh more on Group reported margins.

• Square Enix has historically been known for prolonged game development, leading to delayed and over-budget games. Extended development periods between major title launches can lead to higher development costs, hindering margin expansion in the HD Games subsegment. However, we have so far observed a smooth development process for its upcoming games, especially in its internal original franchises. 

• For many of Square Enix's games, budgets are loosely set. We find that the company is concerned that tight cost controls may squeeze creativity. Square Enix needs to strike a balance between providing an environment conducive to creative risk-taking and keeping costs under control.

Appendix – Main pipeline game product descriptions:

• Final Fantasy XVI is the next major game in the Final Fantasy franchise and is being developed by Creative Business Unit III with Naoki Yoshida as lead producer. Creative Business Unit III is responsible for the massively successful Final Fantasy Online where Naoki Yoshida is the director and producer of the game. We have high confidence in the team and high expectations that the game will be successful. Final Fantasy XVI will have a darker aesthetic and game world, with the content being both appealing to Japanese and western gamers. It’s worth noting that Final Fantasy Online has seen its North American and European user base grow at a rapid pace, and it continues to represent the majority of the game’s subscriber base - we believe that the Final Fantasy franchise, while already popular in western markets compared to most Japanese RPGs, still has room to continue expanding in the west. Final Fantasy XVI is slated to release between June and September 2023. To put into perspective the potential for Final Fantasy XVI, the previous entry in the series, Final Fantasy XV, has sold over 10M units to date and we think Final Fantasy XVI will surpass this. 

• Final Fantasy VII Rebirth (or Part II) is the second game in a series of planned remakes of the 1997 classic, Final Fantasy VII. The first game in the remake series has sold over 5 million copies to date. In Japan the game sold over 1 million copies in its first week and in the United States, Final Fantasy VII Remake became the fastest-selling Final Fantasy title in the history of the franchise, surpassing Final Fantasy XV. The original 1997 game is often considered one of the top 3 in the franchise, and over its lifetime has sold over 13.3 million units worldwide. Final Fantasy VII has a devoted following and we expect Final Fantasy VII Rebirth to generate a similar level of sales to Remake (or “Part I”). Final Fantasy VII Rebirth is slated to release between Dec-2023 and March-2024. 

• Forspoken is a new original IP developed by Luminous Productions (a Japanese-based Square Enix studio). Forspoken is an open world magic-based action RPG aimed at targeting primarily western markets with a broader appeal compared with Square Enix’s other RPGs such as Final Fantasy and Dragon Quest. The games writing team includes Gary Whitta (Star Wars Rogue One) and Amy Hennig (Unchartered series) and is expected to play out more like what a gamer would expect from a western action RPG. Forspoken is an ambitious project that incorporates unique gameplay mechanics that include a fast-paced parkour-like traversal system and an entirely magic-based combat system. The game is a next-gen PlayStation 5 and PC timed-exclusive and is being released with the aim to “achieve the highest quality visuals ever seen in an open-world game”. Square Enix has a long history of pushing the boundaries of what’s possible when it comes to AAA quality graphics and cinematic storytelling, and we think Forspoken is their next showcase and could become a go-to game for those players wanting to experience a new-gen AAA open-world game on the latest consoles. Forspoken releases on 24 January 2023. 

• Dragon Quest XII: The Flames of Fate is the next main game and numbered entry in the Dragon Quest franchise and is being developed and published by Square Enix. The Dragon Quest franchise is 35 years old and over its lifetime the franchise has continued to be extremely successful in Japan. In fact, the game is so successful in Japan that there is an urban myth that the Japanese government had mandated that Enix release Dragon Quest games only on Saturdays to prevent kids and adults from calling in sick at school and work. In the west, however, the franchise has only recently been receiving attention, mainly because of Dragon Quest XI, which was a hit among RPG fans. Dragon Quest XI, however, was only released one year after the Japanese launch. The game included English localization and the Switch version included English voiceover. As of Sep-2020 Dragon Quest XI has sold over 6M units and we estimate 2M of those units were sales from outside of Japan (previous entries were virtually all Japan sales). We believe that with growing positive reception and interest from western players, Square Enix is looking to target the west more meaningfully with the Dragon Quest IP. Dragon Quest XII: The Flames of Fate will be a simultaneous global release, will take on a “darker” theme and is developed for a more mature audience (with potentially more realism), is being developed using Unreal Engine 5, will incorporate player choice which affects the game world (potentially less linear than previous games), and will see an overhauled combat system (though we aren’t sure how far of a departure this will be from the franchises tradition Japanese RPG turn-based system). From what we’ve seen thus far, Dragon Quest XII appears to be taking on a more modern approach that could attract both its core Japanese audience and attract more western players. We think Dragon Quest XII will surpass the lifetime sales of Dragon Quest XI and will continue the IPs expansion into western markets. If Dragon Quest follows its previous five-year release cycle, Dragon Quest XII should release in 2022. However, we expect it’s more likely the game will be released in 2023. 

• Kingdom Hearts IV is the next main game and numbered entry in the Kingdom Hearts franchise. The game is being developed in Unreal Engine 5, and while we don’t know much about the game, a recent trailer suggests the game will include more realism. This game is likely the furthest away from being released. We expect Kingdom Hearts IV will launch in 2024/2025.  

Catalyst

• The launches of the next main games in Square Enix’s major game series which should begin to show early signs of long-term margin improvement in Square Enix’s HD Games subsegment. 

• Pipeline announcements of internally developed mobile games and their releases, which should start to drive structurally better margins in the Games for Smart Devices / PC Browser subsegment. 

• New major content updates to Final Fantasy Online, with closest being Island Sanctuaries (likely Sep).