Top News
#1: Embracer Loses Pivotal Partnership in Major Blow to Profitability
Embracer Group stock plunged by -45% in Stockholm on May 24th after reporting FY2023 earnings (ending March 31, 2023) and slashing its forecast for the 2024 fiscal year. The Swedish gaming conglomerate cut its adjusted EBIT forecast from SEK 10.3 - 13.6 billion to SEK 7 - 9 billion, a 33% decline, on the loss of a “groundbreaking strategic partnership,” which it had been touting for several months.
Embracer had previously communicated in March that the deal, as well as a number of other licensing deals, would still be closed, albeit with a one-quarter delay. Then on May 15th, the company issued a press release revising its EBIT forecast from SEK 8 - 10 billion to SEK 6.35 billion for the current fiscal year because the deals had not yet closed. Adjusted EBIT came in at SEK 6.37 billion, in-line with this revised forecast.
While the dip in March was quickly reversed, Embracer stock has fallen continuously since the mid-May press release. This latest dramatic decline ranks as the steepest single-day percentage plunge for a large games company in at least the last decade. As of May 25th, the company’s market capitalization of SEK 26.4 billion ($2.4 billion) has wiped out all post-COVID gains, and it’s now 80% lower than the peak valuation of SEK 133.4 billion ($12.3 billion) reached in May 2021.
Not much is known about the deal that fell through other than its magnitude and the abruptness of its termination. Embracer noted on its earnings release that the company would have generated more than $2 billion in contracted development revenue over a six-year period. The loss of this partnership is particularly painful as the company notes that the already announced deals provide “more limited short-term financial value.” In contrast, this one would’ve had long-term profit and cash flow predictability. From a communications perspective, this mega-deal has been talked up since FY23 Q2, which was published last November.
According to the company, negotiations had been taking place for seven months — since Embracer secured a verbal commitment from the prospective partner last October. Embracer CEO Lars Wingefors stated that “all documentation was finalized and ready to go” just one day prior to their earnings release, but the partner backed out at the eleventh hour. There is no word yet on whether any terms were violated, which may lead Embracer to seek legal recourse.
Since its spin out from Nordic Games Group in 2016, Embracer Group has been on an acquisition and licensing spree. Notable acquisitions include Saber Interactive in February 2020 in a $525 million deal, Gearbox Software in February 2021 for $1.3 billion, and Asmodee in December 2021 for €2.8 billion. Embracer’s enterprise value of SEK 43.5 billion today ($4 billion) is lower than the combined price of these three purchases alone. Embracer has around 15,000 employees; for comparison, EA, with 12,000 employees, has an enterprise value eight times higher at $34 billion.
Furthermore, the company has taken on debt to finance these purchases. At the end of FY2021, Embracer had SEK 1.5 billion in total debt, whereas today it has SEK 21.7 billion. Cash is nominal at SEK 4.7 billion, for a net debt position of about SEK 17 billion. The EBIT-to-interest coverage ratio has declined to a worrisome 1.9x, indicating that further profitability declines could jeopardize the company’s ability to pay back bondholders.
Even at the low end of the EBIT forecast for the coming fiscal year, Embracer can still cover the interest on its debt. However, there is little to no room for any other debt-funded acquisitions, which will limit inorganic revenue growth in the near term. Given the company’s massive decline in equity value and low cash levels on the balance sheet, it would be prudent to avoid acquisitions altogether until profitability can grow sustainably.
Wingefors noted that the next 12 months will be very challenging, but FY25 and FY26 will benefit from a “strong pipeline of highly anticipated games” based on Embracer’s own and licensed IP. On May 15th, Embracer announced a new Lord of the Rings MMO, which will be published by Amazon Games and developed by Embracer’s Middle-earth Enterprises subsidiary. Embracer purchased Middle-Earth last August in order to acquire complete media rights to Lord of the Rings and The Hobbit and begin licensing new projects based on the IP, though it must still work with other rights-holders like the Tolkien Estate and LOTR trilogy producer New Line Cinema under certain circumstances.
The MMO announcement did not appear to receive much fanfare for a couple of reasons. For one, it was overshadowed by Embracer’s profit warning six hours later, which caused the stock to plunge. Another reason may be due to Amazon’s questionable track record with releasing MMOs. In September 2021, Amazon Games published New World, which was developed by the in-house studio Amazon Games Orange County. Updates have been scant since launch, partially owing to the game’s pay-to-play model instead of a subscription model like a traditional MMO.
While all MMOs experience player declines over time, many have seasons (usually every quarter) that boost engagement as players vie to complete all of the seasonal content. Since launch, New World has kept the level cap and gear cap the same while adding comparatively little content. The game added seasons this February, but this update came too late, given the number of average players has fallen over 95% since launch.
Amazon’s other published MMO Lost Ark, which was released to Western audiences in February 2022, has fared a bit better. The game is free-to-play and follows a more modern MMO formula. Unlike New World, which only averages 14,000 players today, Lost Ark averages around 60,000. That’s an improvement but still not great given the level of investment. Embracer will want to partner closely with Amazon and ensure it’s putting out regular content updates for its Lord of the Rings game to maximize its chances of success.
It’s now clear that Embracer’s strategy of overpaying for acquisitions and rolling them up into the broader portfolio has failed entirely. The company states that its approach is to “empower acquired companies in order to enable accelerated organic growth,” but there is no evidence these acquired companies’ organic growth is any better than before they were bought. Revenue growth is just one piece of the puzzle, and Embracer has struggled to deliver healthy margins as a result of company-wide bloat.
The focus must now shift to maximizing efficiency for Embracer’s 12 operative groups and 15,000 employees. Given the extremely high employee count for a company with a market capitalization that barely qualifies as mid-cap anymore, we should expect layoffs, reprioritization of projects, and outright studio sales on the horizon. But even “crown jewels” in the portfolio, like Gearbox, appear to be worth much less than what they were purchased for. Gearbox was acquired for $1.3 billion in February 2021, at the valuation peak for technology companies. But the developer has yet to develop or publish any notable titles since.
At six times EV to next year’s EBIT, Embracer Group stock is extremely “cheap.” Investors are doubtful that the company will be able to control costs in the near term given the massive headcount and overhead and also skeptical that FY2025 and beyond will deliver improved results. Embracer’s best bet is probably to pare down acquisitions for the next two or three years and use any free cash flow to service the debt load. Wingefors’ claim that Embracer is near a “notable inflection point” in its business is questionable, given its 130-plus subsidiaries have yet to put out a truly standout title, and there do not appear to be any other transformative deals on the horizon either.
#2: Sony Showcases its Stranglehold over Microsoft
At its PlayStation Showcase last week, Sony unveiled its upcoming slate of games coming out this year for PS4, PS5, and PSVR 2, along with a couple of hardware surprises. Over two dozen titles were revealed during the event, and while many were exclusive, some will also be making their way to Xbox. This was the first PlayStation Showcase since September 2021, after the 2022 version was canceled, reportedly because it would have strengthened Microsoft’s case to the CMA regarding its second-place status in gaming vis a vis the Activision Blizzard acquisition.
Sony’s 74-minute-long showcase was mostly packed with third-party developers. Four first-party studios showed off their upcoming titles, including a surprise announcement from Destiny developer Bungie, which Sony acquired back in January 2022 for $3.7 billion. The event began with Fairgame$ from Jade Raymond’s Haven Studios, described as a “competitive heist experience” that looks a lot like Starbreeze’s Payday. Like Payday, Haven’s game will also be available on PC, and it appears to be a live service title. No release date was announced.
The second in-house title was Concord from Firewalk Studios, a PvP multiplayer first-person shooter coming to PS5 and PC in 2024. The trailer did not reveal many details about the game, and the game’s write-up on the PlayStation blog by game director Ryan Ellis was similarly scant. What we do know is Concord will feature a “unique universe of vibrant worlds” with a “rich cast of colorful characters.”
The next two reveals, which included the final pair of first-party reveals of the showcase, were widely considered the highlights of the show. The first was Bungie’s Marathon, the company’s critically acclaimed first-person shooter trilogy that concluded with Marathon Infinity in 1996. Marathon’s sci-fi setting inspired both the Halo series and Destiny. Unlike the original series, this newest Marathon game will be an extraction shooter, a genre popularized by Escape from Tarkov. No release date was given, but in February 2021, Bungie stated that a new IP would be coming out by 2025. The game will be released on PS5, Xbox Series X, and PC and will feature cross-play, likely in an effort to placate regulators.
Closing out the show was 12 minutes of gameplay for Marvel’s Spider-Man 2, which was initially revealed at the PlayStation Showcase in 2021. Unlike its other first-party games on display, Spider-Man 2 will be entirely single-player. The title will be exclusive to the PS5 and released in Fall 2023. However, Sony Interactive Entertainment head Jim Ryan said that exclusives would make their way to PC in “two to three years” in a recent interview with Famitsu.
The event received a mixed reception from viewers. Some fans were divided over the relative lack of first-party exclusives, use of CGI trailers rather than gameplay footage, and the absence of release dates for many titles. Some of this may have been deliberate, as PlayStation may have been holding back on content yet again in light of its case against Microsoft.
In the surprise hardware department, Sony revealed its first handheld since the PlayStation Vita, which was first released in Japan in 2011. The new device, which is similar in design to the Switch and Steam Deck and codenamed Project Q, features an eight-inch screen connected by the two ends of a DualShock controller. Project Q requires the user to own a PS5, as it only streams games over Wi-Fi instead of allowing owners to digitally download titles like with Nintendo and Valve's handhelds. It will feature a 1080p display and be capable of gaming at 60 frames per second, but technical details about the internals were not divulged during the presentation.
Project Q is the first handheld that is focused on game streaming. If Sony is able to execute well and truly minimize latency while maintaining high-quality streaming bandwidth, the device should do well with the core PS5 fanbase. Given that the handheld is only useful to PS5 owners, it’s now more clear than ever that Sony is trying to create a closed ecosystem similar to Apple that will facilitate consumer lock-in. Project Q is very much an experiment in this new format, and it will be a proving ground for future devices that may be focused on cellular streaming for a “play anywhere” experience.
The other hardware shown off last week was Sony’s first earbuds for PlayStation. The Bluetooth-enabled wireless earbuds feature “new wireless technology developed by SIE” to deliver lossless audio with minimal latency. Both Project Q and the earbuds will be available later this year.
Sony is walking a fine tightrope on the software front, having convinced regulators that Activision Blizzard could unduly harm its business and the broader gaming market. However, in that same interview, Ryan said Sony was committed to "increasing the number of PS5-exclusive titles and staggering the release of the PC version.” This sort of behavior is what the CMA and FTC are trying to get Microsoft to avoid, which it has by signing lengthy licensing deals for Activision crown jewel Call of Duty.
Sony purchased Bungie less than two weeks after Microsoft’s Activision Blizzard merger announcement. The FTC also reviewed the Bungie deal, and it appears the agency is now the new, more austere trier of fact for video game acquisitions, rather than the U.S. Justice Department. Sony closed the deal seven months later with no apparent concessions. On the other hand, the FTC waited nearly a year to file its lawsuit against Microsoft, and the acquisition status of Activision remains ambiguous 17 months after it was first announced.
Microsoft tweeted that a dozen titles shown during the PlayStation Showcase would also be coming to Xbox shortly after the event. But Sony’s event accomplished its goal of sapping excitement for Xbox Games Showcase 2023, which is set for June 11th. By going first, Sony was able to maximize the marketing value of unveiling highly anticipated cross-platform games like Marathon, Alan Wake 2, and Assassin’s Creed Mirage. This leaves Microsoft to rely on its own first-party games to make a splash, of which there are few.
Microsoft has been put in an awkward place by the recent failure of Redfall. The game, which was published by Bethesda Softworks (but developed by Arkane Studios), was one of the worst-received AAA games of the year, despite being hyped up by Microsoft as a killer exclusive. PlayStation exclusives are frequently met with acclaim, but Xbox continues to fall flat with its original IP outside of franchise titles like Forza.
Bethesda has a chance to reclaim itself with Starfield, which has been the most anticipated Xbox title since it was announced at E3 2018. The game is both developed and published by Bethesda, and it’s the studio’s first original IP since Protector for the Atari Jaguar in 1999. Starfield was supposed to launch last November but has since been delayed twice. It’s now scheduled for September 6th. With all Xbox’s eggs in one basket, negative reception for Starfield would be an unmitigated disaster for Microsoft Gaming CEO Phil Spencer, who has already profusely apologized for Redfall and Xbox’s overall failure to execute on the first-party front.
Another awkward spot for Microsoft now concerns its lack of a handheld. The Nintendo Switch has sparked a resurgence in the format, bolstered by the easy availability of digital downloads and advancements in cloud gaming, which help eliminate storage space as a constraint. It’s unclear whether Sony’s experiment with a device that is only compatible with another $400 console will pay off, but the company will at least have a device on the market to experiment with and build upon. Microsoft does not yet have this luxury, apart from xCloud, which can be accessed on the go by using the mobile browser on a smartphone or tablet. If Microsoft is working on a proper handheld, we are very likely to hear about it at the Xbox event in June.
Sony’s 2023 PlayStation Showcase has showcased its lead over Xbox for all to see. The Japanese technology company leads Microsoft in gaming, and it will only expand its lead if the Activision Blizzard acquisition does not close. Sony has opened a new front on the hardware arena with the PSVR 2 this February and now Project Q, which is coming later this year. Microsoft is reportedly working on its own VR device based on patents filed this April, but this device might not be Xbox branded or even target gamers at all. The company’s HoloLens headset, for example, is explicitly for business customers and enterprises.
Sony had an $8.3 billion lead in gaming revenues over Microsoft in FY2021 and an $8.9 billion lead in FY2022. As it stands now, this delta is set to grow, given Sony’s Bungie acquisition is paying rapid dividends while Microsoft still has little to show for itself. Loyalty is an important factor, but it will slowly erode over time without notable expansions to the Game Pass library. If Sony is able to turn PSVR 2 and its upcoming handheld into must-have accessories, this drift will only accelerate.
Top Movers
- For the week ending May 26th, 2023: the average return for gaming companies tracked by Naavik with a market capitalization exceeding $500 million was -3.5%. The S&P 500 returned 0.3% and the Nasdaq-100 returned 3.6%.
- Megacap tech stocks surged after Nvidia issued guidance for the next quarter that was significantly above expectations. The Nasdaq-100 index closed the week at new 52-week highs and is just 14% from its all-time high last November. Gaming stocks fared poorly, falling an average of -3.5%, as Embracer’s earnings guidance reverberated through the whole sector.
- Embracer Group plummeted by -42.8% after cutting its EBIT forecast by 33% for the 2024 fiscal year. This comes after the group lost out on a “transformative” licensing partner that would have added $2 billion in revenue over the next six years. Embracer’s earnings are covered in more detail in the Top News section.
- Sea Ltd. fell -13.4%, continuing its decline after falling -18.1% the week prior on lackluster earnings. The Garena gaming segment continues to pose trouble for the Singapore technology group, which could not be pared by more positive performance in the digital payments unit SeaMoney or the ecommerce unit Shopee.
Most Notable Venture Financings
- Mobile gaming startup BebopBee raised $4 million in venture funding led by Bitkraft, which previously led the studio’s $3 million seed round in February 2021. These latest funds will be allocated towards the development of Travel Crush, a Match 3 game on iOS and Google Play with social elements such as team chat. Travel Crush aims to “connect people across cultures and locations” by introducing the audience to a new city every month to compete in. CEO Rajeev Nagpal said that the game would continue to follow a “community-first approach.” BebopBee is headquartered in Seattle and has 24 employees, according to its website, with eight open roles. (Link)
- Openfort, a crypto account company for game developers, raised $3 million in seed funding. The platform provides infrastructure for Web3 game developers and game DAOs to integrate wallet solutions into their gaming projects, providing the entire backend in a developer-friendly format. The service is available on Unity, Unreal Engine, and React, while the company is working on an SDK for mobile gaming. The Openfort team consists of four individuals, including brothers Joan and Jaume Alavedra, who co-founded the company last September. (Link)
Other News
- Sony significantly scaled down the multiplayer project for Naughty Dog’s The Last of Us. Following a review by Bungie, the game’s quality and engagement potential were deemed unsatisfactory, leading to many employees being called off the project and shifted elsewhere. Naughty Dog’s statement also included news that development has begun on a new single-player game. (Link)
- One of Enad Global 7’s largest shareholders has called for the company to consider strategic alternatives. Alta Fox Opportunities Fund, which holds a 6% stake in EG7, asked the board to pursue options ranging from selling the company outright to initiating a large dividend and listing the stock on a U.S. exchange. Alta Fox pointed out that EG7 is significantly undervalued versus its gaming peers, trading at 4x forward EBITDA and a 15% FCF yield. (Link)
- The developers of The Lord of the Rings: Gollum issued an apology in reaction to the game’s negative reception. Gollum was critically panned for its myriad of technical issues as well as core problems plaguing the story and gameplay. The team has stated they will work on patching the bugs but did not mention any other fixes. (Link)
- China’s antitrust regulator approved Microsoft’s acquisition of Activision Blizzard unconditionally. This leaves the FTC in the U.S. as the last major regulatory body to issue a decision. Microsoft also appealed the CMA’s decision in the U.K. last week, claiming the regulator made “fundamental errors” in its judgment. (Link)
A big thanks to Mario Stefanidis, CFA for writing this update! If Naavik can be of help as you build or fund games, please reach out.
