Over 2020, there was an emerging games business model that many in the industry newly came to understand - the rollup entity. Key example companies include Stillfront, Embracer, Thunderful, and EG7. Even though all these companies made larger names for themselves during 2020, which turned into a breakout year, the business model remained generally under-followed at the time.
The promise of this business model was to predictably grow shareholder value in a highly unpredictable market. In practice, that meant executing on a well engineered strategy centered around selective M&A moves, fueled by smart capital allocation tactics, resulting in highly synergistic group operations, and in turn driving the entire business to higher heights. Read our previous deep dive into Stillfront for more details. In short, however, the viability of the model hinged on opportunistically buying quality assets at reasonable values, as well as proving that all these subsidiary companies being under one roof could create more value than if they were separate. These were big assumptions and questions with lots of believers and lots of skeptics.
While the expected result of this strategy was to bring consistency and scalability to an otherwise lumpy and hits-driven industry, the subsequent stock price trend for each of the four example businesses tells a very different story. As of April 5th 2022, each of these publicly traded companies is significantly down from its 52-week stock price highs and generally back to prices last seen over a year ago:
- EG7 is down -79%
- Stillfront is down -68%
- Embracer is down -34%
- Thunderful is down -26%
What happened? From a macro perspective, the world got vaccinated, post-COVID trends hurt engagement, IDFA deprecation occurred, and the stock market whacked growth/tech/game-oriented companies, most of which were trading at historically lofty valuations. And, of course, from a micro lens each of these specific roll-up companies pursued aggressive M&A strategies that seemingly failed to live up to their goals of “predictable, growing businesses in unpredictable, volatile markets” — at least in 2021
As we enter a less frothy market environment, it’s worth looking back at what happened in the past couple years and identify key risks these roll-up businesses face moving forward.
#1: Less Flexible Financing
Even though organic (non-M&A) growth is the metric that proves whether the roll-up strategy results in real added value, inorganic growth (M&A) is still the primary means of revenue expansion.
In most roll-up corporations, each acquired subsidiary runs its own autonomous (and usually profitable) business, and the leftover cash — plus whatever money the company raises in other ways — heads to HQ, where the central capital allocation team decides how to best reinvest it. Let’s use Stillfront as an example here. Part of what makes Stillfront work is that it employs a flexible financing approach (various mixtures of cash on hand, debt, and stock) to strike its M&A deals. And as you can imagine, over the past couple years it’s been a mostly great environment to operate in. The core business was profitable which provided cash to reinvest, interest rates were very low which made debt easy to leverage, and Stillfront’s public stock price traded at much higher multiples than the companies it acquired, which enabled it create value via financial engineering. As long as Stillfront — and all the other companies like it — could find quality targets, there was a reasonable means of acquiring them, often still with long-term incentives to perform.
However, all good things must come to an end. A company only has so much cash, can only take on so much debt (especially as interest rates creep up), and stock prices don’t stay at historically high multiples forever. Take Stillfront’s metrics as an example. As Stillfront scaled up M&A, it had to ramp up debt much faster than it could grow its cash flows, and shareholders became increasingly diluted in the process. The company now has approximately four times as much debt as cash, and the company’s leverage ratio — defined as net debt / Adjusted EBITDA — recently hit 1.6x, which is the first time it’s been higher than management’s 1.5x target. Stillfront makes plenty of cash to eventually pay down its low interest rate debt, and it’ll continue to strike deals, but having a super debt-leaning balance sheet provides less flexibility to safely make big deals using cash going forward.
Outsized debt is one component that makes deal making more fragile, but it’s not the only financial tool that offers less flexibility than it used to. Stillfront’s stock, which now only trades at ~2.5x sales (down from over 7x a year ago), also has become a less usable currency for deals. There’s a reflexive feedback cycle here: if a roll-up company’s stock price falls, it becomes harder to use its shares as currency (because it makes deals more dilutive), which means it’ll strike fewer deals, which decreases revenue growth, which drives the stock price further down. Live by the sword, die by the sword.
We used Stillfront as an example here, but similar trends exist among most gaming roll-up companies.
#2: Finite M&A Opportunities
Even though the M&A market has been sizzling over the last 2 years, finding new and actionable targets that also make sense within each company’s unique acquisition strategy is getting increasingly harder. Yes, there’s an increasing number of potential buyers, but also the appetite for acquisitions is more rampant than the pace at which the market can generate new M&A targets. As can be seen below, especially when looking at Q4, the number of M&A deals struck by each company has generally trended downwards.
More specifically for Embracer, even though the company has been able to maintain a relatively healthy deal volume versus the rest, it’s more recent M&A targets seem less and less focused on a singular strategy that can unlock synergies across the group more instantly. Instead, it seems like Embracer is trying to lean into expanding its pool of potential M&A targets by broadening its own definition of “gaming-related M&A.” The company seems to be going slightly transmedia with its acquisitions, and thereby derisking revenue growth and EBIT margins through a more unique approach towards portfolio diversification. For example, Embracer’s recent acquisitions of Dark Horse Comics and Asmodee (a global leader in board games) would fit this thinking.
Through an optimistic lens, these acquisitions (even if questionable) are potentially more synergistic than acquiring various non-related studios. After all, there is a limit to how much value independent studios can create for each other, whereas with Comics/Board Games there still could be a path to leveraging IPs (in both directions) and in new ways. Through a more pragmatic lens, however, the immediate synergistic upside of such a strategy is slightly hard to see, and it may take years for a board game IP to get internally developed into a hit mobile F2P game, which later builds enough lore to justify a comic book line. Moreover, I’d expect these transmedia M&A wells to be even less deep (both in terms of number of targets and potential business opportunity) than that of gaming studios.
Switching to Stillfront — while it previously maintained a steady rate of one acquisition per quarter, it has more recently started exploring the acquisitions of individual games versus full companies. This is not a great sign given a rollup company’s core growth strategy hinges on making bigger M&A moves over time. On one hand, buying a flurry of individual games can add up and drive efficiencies by giving existing teams / systems another game to operate and scale. However, on the other hand, what drives long-term organic growth is having more great people working on new needle-moving projects that can take existing subsidiaries and IP to new heights.
All of this forces the rollup companies in two possible directions. First, each company needs to find a way to get even more aggressive with closing more, bigger and higher quality M&A deals. This strategy is of course weakened by both the decreasing pool of potential M&A targets and a lowered financial flexibility due to the weak stock price. Therefore, and second, the pressure is on for these rollup entities to lean into the inevitable second direction - organic growth.
#3: But Where is the Organic Growth?
As mentioned above, financial engineering and inorganic growth can only get a company so far. At the end of the day, what matters most is whether all of these acquired subsidiaries can generate consistent cash and perform better when together than apart. That’s the pitch companies like Embracer and Stillfront make — with their centers of excellence, family vibes, and cross-team teachings. It’s worth asking whether these promises of synergy are actually coming true or if it is mostly a myth.
More recently, Stillfront has started to report organic growth, which is a clear sign of how important this conversation (and avenue for continued business growth) is becoming both internally and for shareholders. As can be seen below, the vast majority of Stillfront’s growth continues to be inorganic, while organic growth was even negative over Q4 2021. More shockingly, organic growth has actually trended downwards for Stillfront over the past two years (15.9% over 2020, and -7.8% over 2021).
In other words, not only has Stillfront’s acquired studio portfolio been unable to release new hit games, but the company’s existing games are also not growing healthily. This isn’t too surprising, though, because the kinds of games that Stillfront is trying to grow are legacy titles with massive long-tails. Therefore, new user acquisition and/or reactivation does not have significant long-term upside, and it also requires high levels of targeting that the post-IDFA world is not really helping with. Further, live operations needs to be world class to maximize revenue upside from these 3-5+ year old games. It is also no secret that Stillfront has also acquired various tier-2 studios, which does impact the quality of talent and technology running the live operations activities.
Embracer’s story is slightly similar. Even though Q3 2021 organic growth was up +16%, this may be unsustainably high, and the majority of the company’s growth continues to be inorganic. Plus, even though the number of titles in the production pipeline plus investment in new titles continues to increase, there’s a very real risk that these efforts don’t pan out, which limits organic growth.
This uncertainty is underscored by how Embracer’s M&A strategy is mainly rooted in PC/Console versus mobile. With PC/Console, not only do the games need to be top quality at launch, but they also won’t have the same revenue long tails as GaaS-driven mobile games. Therefore, Embracer needs to sustain a massive new project pipeline so that the risk of high PC/Console project development time and budgets is balanced out. The number of pipeline projects has now increased to 215 (vs 54 in Q1 2018).
That said, much of the pipeline is unproven, which makes it tough to grasp what long-term organic growth will be. Interestingly enough, one way to counter this risk is to start building out the GaaS business vertical, and it definitely seems like recurring mobile revenue is gaining a larger foothold through Embracer’s portfolio. But I don’t see a why the same reasons plaguing Stillfront’s ability to grow organically on mobile will not impact Embracer down the line.
So, what’s next for rollup entities?
Looking forward, the big question is: how do these rollup entities reverse their current trajectory? Based on all the above, there are two clear paths that can be pursued simultaneously:
- Increase the quality of M&A transactions (which likely means doing fewer deals)
- Increase organic revenue growth, through -
a. Launching more games to find the next hit, and then doubling down on scaling them
b. Increasing the existing portfolio’s lifetime by leveling up in-house UA and live-ops talent + technologyc. Pursuing very specific cross-studio strategies to create new synergistic avenues of organic revenue growth
While this hard to do in a highly competitive M&A climate, it’s also safe to assume that each rollup entity is learning a tremendous amount with every successive deal it makes. In other words, as long as the M&A target selection razor is constantly becoming sharper in the context of a broader portfolio building strategy, the chance to strike higher quality deals will improve over time. That will eventually funnel into healthy organic growth, which is also a sign of whether these roll-up entities were disciplined enough with their quality bars or sacrificed quality for quantity (short-term inorganic growth at the expense of long-term organic growth).
Finally, its not like the rollup entities are oblivious to these strategies, and a lot of this is easier said than done. Competition is fierce, creating synergies is challenging, and none of these acquirers control market prices. All they can control is their own behavior. Maximizing success is deeply rooted in leadership’s ability to rally all employees and subsidiaries around a common goal, steadily increase the quality of execution across all teams, and have the diligence to only pursue deals that maximize per share value (not just grow for growth’s sake). One thing is clear: not all roll-up companies will be able to adapt and improve equally. Some companies will become smarter and more disciplined while others will continue to inefficiently build their empires. Only time will tell which is which.
Big thanks to Abhimanyu Kumar for writing this essay!
