Description

Summary

Ubisoft is a leading video game publisher with well-known AAA titles such as Tom Clancy Rainbow Six Siege, Assassins Creed, Far Cry, and Watch Dogs Legion and co-founder Yves Guillomet serving as CEO. We believe an investment in Ubisoft (Euronext: UBI FP) is currently an attractive risk-reward as several factors have put a lid on shares, including: 1) reports of cultural issues at the company; 2) the rotation away from ‘stay at home’ stocks; 3) execution missteps from FY20; 4) recent delays pushing a game launch from FY21 to FY22. We believe management is proactively addressing these issues, and believe the stock offers an ~85% return by the end of March 2022 years with limited risk of material permanent capital impairment.

Investment Thesis:

Summary: We believe that Ubisoft will see an acceleration in revenue and profit growth over the next few years as a result of decreasing barriers to play video games (Streaming / Free to Play), expansion into untapped markets (China / Mobile), and pricing increases (inflation in AAA game pricing). The impact to profit growth will be outsized for Ubisoft as the company has runway to catch up to other western peers in its digital mix, and monetization of ongoing play. We believe Microsoft’s acquisition of Bethesda for $7bn (9/20) draws a line underneath Ubisoft’s share price and limits the risk of permanent capital impairment given the intensity of interest in Video Game M&A from large tech companies launching gaming platforms including Google Stadia, Amazon Luna, NVIDIA GeForce Now and Facebook Gaming, in addition to Sony PlayStation and Microsoft XBOX. Ubisoft’s ownership of IP, large development capability, and broad consumer interest in its existing portfolio make it one of these companies’ most attractive targets.

Thesis:

1. Video games are structurally attractive, and demand is accelerating; Ubisoft is well-positioned to benefit from these trends.
2. Ubisoft will see sales and profit accelerate as it catches up to peers in benefiting from additional channels, monetization strategies, and pricing changes.
3. Active M&A market in video games with well-capitalized players, where Ubisoft would be an attractive target.
4. Management has an opportunity to address cultural challenges to become a leader in transforming the game industry, which will drive significant shareholder value.

1. Ubisoft is well-positioned as a founder-led company to benefit from the structurally attractive video game market, which enjoys accelerating growth from both near-term and long-term drivers.

• Structurally Attractive:
  • Video games are a structurally attractive market due to the digital relationship that game publishers develop with customers, allowing for ongoing monetization, game level network effects, and high fixed cost leverage.
  • Declining AAA Launches: Growing complexity of game development– through graphical intensity, story development, multi-player requirements - increases fixed costs, decreasing industry attractiveness for new entrants, and benefits players with existing IP and more certain demand.
  • AAA titles now cost $100mn+ to develop and require $35mn+ to market, which has consolidated the number of AAA launched per year over the last decade
• Near Term Accelerants
  • COVID: Coronavirus has limited entertainment and leisure options for consumers, with gaming being a significant beneficiary. Gaming has seen an increase in players’ time and also in breadth, with new players using video games to engage socially with others.  It has also benefitted from expanded budgets resulting both from lower spending on other activities and consumer stimulus. We believe there has been a permanent increase in gaming addressable market.
    • Ubisoft is a beneficiary from this dynamic as one of the AAA producers who generates profits from enhanced engagement as well as launching three AAA titles during the fourth calendar quarter: Watch Dogs Legion, Assassins Creed, and Immortals Fenyx Rising. We expect sales to benefit from the recent lockdowns, benefiting near-term performance and ongoing monetization longer term.
    • Ubisoft has already commented to the market that Assassins Creed sales are the best in franchise history, and Watch Dogs legion sales have been solid. Immortals Fenyx Rising has received good critical feedback and is positioned towards a different segment than Cyberpunk 2077
  • Attractive Game Slate: Ubisoft has an attractive future game slate to further build on its strong recent launches that balance new IP with launches under existing franchises, including Far Cry 6, Rainbow 6 Quarantine, and another AAA title in FY22; and Avatar in FY23 as well as the eventual launch of Beyond Good and Evil 2, which has not received a release date but has a film in production. We believe the announcement of a Splinter Cell game would be well-received, which has been teased by the integration of Sam Fisher into other Tom Clancy games
    • Ubisoft currently has two games in the top 10 most anticipated futures releases according to Gamespot 50 https://www.gamespot.com/gamespot-50/
  • Console Cycle: We are at the beginning stages of a console transition to PS5 and XBOX Series X. Demand for these consoles are extremely high, and they frequently sell out within minutes of new inventory being released.
    • Ubisoft is well-positioned with a strong current slate of games that are next gen optimized, including the recently launched AAA titles. Assassins Creed is currently positioned as one of the ‘must-buy’ games when getting a new console.
  • Long Term Drivers: There are many long-term drivers which are difficult to quantify that are likely to accelerate growth and profitability, including Streaming, Esports, Advertising, and Metaverse “Gaming as a Social Platform.”
    • Ubisoft is well positioned to capture many of these opportunities due to being a founder-led business, having large development capability, and owning a portfolio of quality IP that engages a broad range of consumers.

2. Ubisoft will see sales and profit accelerate as it catches up to peers in benefiting from additional channels, monetization strategies, and digital engagement.

• Ubisoft, alongside Square Enix and Take-Two, is one of a few publicly gaming companies expected to earn operating margins below 30%. We believe this comes down to limited imagination from the market and the benefits the company will reap from the below factors.
• Player Recurring Investment: Ubisoft will increase in-game monetization (PRI) significantly in the next few years to catch up with peers as Ubisoft’s players migrate to more recently launched games with more advanced monetization strategies
  • PRI (excluding mobile) at UBI’s peers is significantly higher – Ubisoft earned 26% of FY19 revenues from PRI vs. ATVI at 45%, EA at 47%, and TTWO at 39%
  • Ubisoft generated 371mn in PRI with 100mn unique players in H1 2021 or a $7.42 run rate vs. FY20 of $6.00 and FY19 of $6.44 in per active player (which excluded Brawlhalla)
  • Ubisoft is closing this gap by using strategies proven by peers to drive PRI, including DLC, season pass, multiplayer, and selling cosmetic items to drive in-game monetization
  • Assassins Creed Valhalla has several enhancements that will drive PRI spend including more activities in the open world, raids and assaults, connectivity with other players, and a settlement camp that players can customize. Ubisoft doubled the post launch content from Origins to Odyssey which we would expect to see again with the strong release of Valhalla
  • Watch Dogs Legion will include a multiplayer mode, which was not present in Watch Dogs 2
• Mobile: Ubisoft will launch a Rainbow Six mobile game in partnership with Tencent in FY22, which we believe will generate 100-150mn in net bookings at 20-30% operating margins:
  • Tencent has had a successful partnership with Activision in which it developed COD mobile, which has seen 300mn player registrations and is expected to generate ~$400mn of net bookings prior to its launch in China
  • We estimate the Rainbow Six player base to 1/3 the size of Call of Duty based on MAU estimates from Gamstat.com, which support our $100-150mn net booking estimate.
  • After the launch of Rainbow Six in FY22, we’d expect more mobile games developed using Ubisoft’s AAA IP and casual games
• Take Rate Decline: every 100bps decline in UBI’s platform take rate equates to $20-30mn of additional sales and profit at current bookings levels.
  • More platforms provide channels to reach consumers beyond Sony, Microsoft, and Nintendo consoles, whether it’s Steam, Epic, Google Stadia, and emerging options through Nvidia, Amazon, and Facebook. Additionally, Ubisoft and other gaming companies have developed a direct channel to reach consumers.
    • Epic has been able to take considerable PC game share from Steam by charging publishers a lower take rate: 12% vs. 20-30%
    • Ubisoft commented that the of Assassins Creed saw the largest number of PC players, which indicates that channel mix is benefiting margins.
    • Other game CEOs have indicated that they are pressuring Sony and Microsoft to lower their take rate through these other channels.
  • Shift to Digital has likely permanently accelerated as a result of COVID and the launch of lower-cost, digital-only consoles.
    • Digital bookings were 87% of bookings in H1 FY21, increasing from 82% in FY20, 69% in FY19 and 58% in FY18
    • Games sold through brick and mortar channels carry ~55% margins vs. 70% margins through digital sales.
    • Additionally, digital sales eliminate second-hand games and allow Ubisoft to capture back-catalog sales for gamers that play older games at bargain prices.
• Pricing Opportunity: €75-115mn opportunity
  • Ubisoft is likely to follow industry pricing changes from Take-Two and comments from other publishers about the price of AAA games increasing from $60-70
  • Pricing for AAA video games have not changed in 15 years, and industry commentary has described the change as inevitable.
    • https://www.polygon.com/2020/7/7/21314545/console-video-game-price-increase-70-video-game-ps5-xbox-series-x
  • If Ubisoft were able to push the price increase through on its AAA titles, the company could see a benefit of €75-115mn or a 15%+ increase in operating profit that would scale with growth.
    • Ubisoft has averaged ~20-30mn units of new games per year (excluding FY20, which had the challenging launch of Ghost Recon Breakpoint) with an average ASP of €30-35mn
  • We believe Ubisoft will start to reap these benefits in FY23 due to the quality of titles that will likely launch that year including, Avatar and Beyond Good and Evil 2

3. Active M&A market in video games with well-capitalized players, where UBI would be an attractive target

• Microsoft’s acquisition of Bethesda has expanded its lead in content over potential new platform entrants and may catalyze a land grab in video game M&A
• Ubisoft is one of the most attractive assets for a large technology company to acquire to seed content for its service
• Ubisoft reaches a vast base of players with over 100mn active players across its games with relative value in reach
• Ubisoft releases a large number of AAA titles than western peers providing a baseline stream of content for a new platform to attract users
  • 6 Franchises and 11 titles sold over 10mn units during the most recent generation of consoles
• Ubisoft owns all of its IP, which limits licensing and exclusivity issues during a sale, which would likely impact EA and, to a lesser extent TTWO
• Large Japanese publishers may have a wider cultural gap than Ubisoft. Additionally, Capcom has a family shareholder, and Square Enix has a founder with a large ownership stake that may limit M&A options.
• Ubisoft is one of the few developers with a proven capability in live services, which is driving an increasing gap between large AAA developers and smaller ones evidenced by Square Enix’s recent challenges with the Avengers launch
• Ubisoft’s cultural challenges have the potential to catalyze a change in ownership now that the company has made the initial changes to remove bad actors

4. Opportunity to become a leader in transforming the gaming industry.

• Finally, we see an opportunity for Ubisoft to take its internal crisis and position itself as a leader in trying to solve the cultural problems embedded in gaming, which we believe will benefit Ubisoft, the gaming industry, and shareholders enormously.
  • We believe the launch of Ubisoft connect and the common gamer profile across platforms is a critical component of addressing toxic culture and eliminating abusive members of the community across multiple platforms simultaneously 
• Revenue Opportunity: Women represent over 40% of gamers and 30%+ of esports viewership but are frequently under-represented in online competitive titles such as first-person shooters, which generate high in-game monetization.
• We believe toxicity in these titles is core to why women have more representation in viewing these games than playing them – TeknoAssociates estimates that Rainbow 6’s player base is 23% women, bringing this up to esports viewing levels of 35% or gamers would drive 12-20%+ increase in revenues with a significant impact to profitability, due to high drop-down margins vs. 20% EBIT margins.
• Additionally, we believe female gamers offer broader partnership opportunities, additional channels for monetization, and the games’ potential to become more broadly integrated in culture.
• Analogs to success here are professional sports, which have significantly broadened their viewership base over the last 20 years and enjoyed a step function increase in profits.
• Talent Opportunity: In addition to direct revenue opportunities, Ubisoft can unlock a talent pool that may be hesitant to work in game development by addressing the toxic culture associated with gaming, which will improve culture, game quality, and talent at the company.
  • Including more women and under-represented people in the development process brings more diverse opinions and a wider talent pool in game development and may help develop games that attract a broader audience.
• Shareholder Benefit: Ubisoft would see a material increase in profits by addressing the industry’s and its own toxic culture, would improve its brand with gamers, and would better position the company with shareholders who want to do well by doing good, which is growing both in the US and more rapidly in Europe.

Financial Forecast

We see Ubisoft approaching 1bn euros in EBIT in FY23 with the following bridge: 

1. Launch of fourth AAA title in FY23 (vs 3 in FY21) adds 300mn of sales and 100mn of EBIT (quantified as the amount lost of shifting Far Cry into FY22 from FY21)
2. Active user growth of 15% to 135mn users (vs. FY20 base of 116mn) due to 6 AAA games being launched in FY21 and 22 and PRI per active user growth from $6.44 in FY19 to $7.50 in FY23 (flat vs. H1 FY21 run rate) adds 250mn of bookings and 150mn of additional EBIT at 60% incremental margins
3. Pricing change: industry pricing change drives 75mn in incremental EBIT
4. Take Rate: DTC sales through Ubisoft connect, increasing PC mix on Epic Store, and pressure on console take rates lowers blended take rate by 200bps adding 50mn of profit
5. Mobile launch of Rainbow 6 game through Tencent and other titles adds 150mn of sales and 50mn of EBIT

Valuation

We believe continued strong execution, positive releases of AAA games, and cultural improvement will reframe Ubisoft as a high-quality entertainment company with a portfolio globally relevant IP that has exposure to secularly growing end-markets. As a result, we believe Ubisoft with re-rate to a high-teens EBIT multiple and trade in line with video game peers on an EV/Sales basis. At 18x EBIT, Ubisoft would be worth 145 per share for 85% upside.

Risks

We believe Ubisoft has an attractive risk reward. We see the major risks to making the investment as follows:

1. Competition in FPS: Increasing competitive intensity in first person shooters causes Rainbow 6 siege engagement and player spend to fall. 
2. Competition from A/AA: Industry tool sets such as Unity and Unreal Engine lower development cost and cause A/AA proliferate and become good enough to engage players and cannibalize time from players playing AAA games.  
3. Overbuilding from Tech Companies: Amazon has been building some AAA games in the background, which are expected to be launched in 2021. Tech companies may have different economics from traditional publishers and erode the attractive industry economics.
4. Execution: As seen in the fall of 2019 with the botched development and release of Ghost Recon, video game companies still have some “hit risk.” Ubisoft is not widely regarded as releasing flawless games.
5. COVID: On a trading basis, we believe shares may be volatile due to the market questions whether FY21 reflected peak earnings

Disclaimer:

This report is for information purpose only and does not serve as investment advice. I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold shares in the issues securities. This position is subject to change at any time.

Catalyst

• Announcement of FY21 Q3 results featuring the 3 AAA titles launched during the quarter early in calendar 2021
• Game Announcements at Ubisoft Forward Events, notably Avatar, Beyond Good and Evil 2 and potentially Splinter Cell
• Launch of major titles in FY21, including the Tencent mobile game