Frontier Developments Share Price Slammed after Slow Initial Sales

Frontier Developments Profit Warning: Shares in games developer Frontier Developments (LON:FDEV) were off by over 33% today as a trading update revealed that sales of it’s latest release were below expectations. With guidance for FY22 knocked back to a rather wide range of £100m-£130m, the amount of uncertainty in the market is reflected by the drop:

Those buying early in the hope of a bounce would have been disappointed as we can see from the chart here. The share appeared to plateau out but then dropped even further. This has not been a good period for equities. The last week has seen an imposition of lockdowns (or the prospect of them) across several European countries as Covid-19 resurfaces. It had been the hope that at the start of the year the virus would be well under control, assisted by vaccines. However this has not happened, and in fact it may be the case that the situation is not as good as the government spin says. Travel-related shares such as IAG or Saga have risen on hope, but recently fell back.

Frontier Developments however could be said to be one of the beneficiaires of lockdown. With people having more time at home with less to do, why not play more games? That seems to have been fully priced in: the share price entered lockdown at around 1000p, but by the start of 2021 had soared to over £32. In some way this was not too dissimilar to another lockdown winner turned profit warning, Best of the Best.

Their history is interesting. Starting off as a small developer, the now-CEO David Braben co-produced the iconic ‘Elite’ game in 1982, which in some ways was way ahead of its time. As computer technology improved, this allowed sequels as well as other strategy based games such as Rollercoaster Tycoon. More recently they have acquired the Jurassic Park rights to produce games for the PC, Playstation and Xbox.

What did the Frontier Developments profit warning say?

This comes in a trading update RNS. Note that a previous announcement was made on the 9 Nov, noting the game release:

Pre-order sales of Jurassic World Evolution 2 were encouraging, with unit
volumes on each platform comparable to the levels achieved by Jurassic World
Evolution in the run-up to its release in June 2018. However, sales of the
game over the initial period following its release have been lower than
expected on the PC platform. We believe this is potentially a short-term
effect from a more crowded release window than expected, with a number of
other highly anticipated titles launching in the same window. Simultaneous
release on PlayStation and Xbox consoles of both digital and physical versions
went ahead smoothly, and console sales numbers are largely as expected.

Whilst they believe the measures are short-term, it is believed the effects will impede the current financial year (ending May 31):

Jurassic World Evolution 2 will be our biggest release and our largest revenue
contributor in this financial year FY22, the 12 months to 31 May 2022. Based
on the lower initial PC sales noted above and the under-performance of Odyssey
in the financial year to date, we are prudently updating our revenue guidance
for FY22 to £100 million to £130 million. The wide guidance range is
indicative of the variability of outcomes across our whole portfolio as we
approach the important holiday season (Thanksgiving and Christmas).

A look at Stockopedia’s forecast reads £140m for this year. This kind of wide range suggests some degree of uncertainty, and at the lower end £100m would be pretty disastrous – only giving a (relatively) small growth over the previous year. There is not necessarily a problem with this, but when shares have growth baked into their price a disappointment can hit it really hard, as we have seen today.

Frontier Developments: The Business

The computer games business has changed drastically since the releases of those ancient games. Nowadays there are several revenue streams and spin-offs possible. Games can even be given away for free, with the developer making money charging for add-ons. Of course this also changes the nature of costs for developers. Games are no longer one-off projects which are closed when the game is released, but more open-ended ones as updates are continually released for the original software.

Frontier themselves have been publicly listed since 2013. This has been very successful for them, allowing them to access capital which is needed to develop software. They have been profitable every year since listing, and also prudently run. Their profit has been retained as increased cash balances and not paid out as dividends. The CEO also owns a large stake in the company (approximately a third), suggesting that interests are aligned.

A real turning point was the acquisition of the Jurassic Park franchise which caused a sharp jump in revenues after 2018. Many of the games before were successful in their own right, but pretty much niche market games. Jurassic Park is much more well-known and despite the original film debuting over 30 years ago is still going strong with the next film release set for 2022. Another factor is that strategy games have also retained their appeal with the target audience with titles such Minecraft, Sim City, Animal Crossing as popular as ever.

So immediately, we can see that of course this isn’t threatening to the company in the short-term or medium term. Net cash is over £40m and sales are rolling in, the timing of which is perhaps in question, but profits – and big ones – are still assured. Naturally the company is very asset light. Most of its assets are intangible, which comprise development costs being capitalised. A lack of depreciation of this item can inflate profits, however I suspect this is not the case here.

One of the arguments here is that these businesses should be quite volatile. The peak earnings cycle of games is very short-term. In a couple of years there will be a new release which occupies the resources of the company. Whilst the older games will still exist and make contributions to revenue, this will be at much lower levels. There is a constant pressure to produce good work – but at Frontier there is also a good track record of this.

Is the Frontier Developments profit warning a buying opportunity?

The difficulty here would be valuing the company, much of which can be very subjective. You could compare to other similar companies, but they would be facing the same challenges. Some of this is summed up by the wide range of estimates given for revenue for this year. If it can have a range of c.30% for a few months ahead, who knows what a few years ahead may bring? By that time many things could have happened; for instance a new type of game may be released. Or a competitor may simply do it better. Another worry is being dependent on a small amount of titles.

So far the market has brushed off these fears; purchasing Frontier Developments has always been expensive relative to current earnings. But people don’t buy for that, it is what the company could become. And on this front it is easy to be positive. The addressable market will mostly likely keep getting bigger, as gaming as expanded from something that was the reserve of teenage boys to a pastime for most adults. In many ways it is also scalable, as making a game in another part of the market is not likely to affect demand for others.

Another factor which I feel may support a high valuation is the possibility of acquisition. Tencent own approximately 9% of the company, and even at the pre-profit warning price, making an offer for the rest of the company would be extremely small change for them. There would be the potential for many synergies across many of the expense categories and reduce volatility for the acquirer. Frontier also carry a relatively large lease liability on what must be their Cambridge office and this cost could be spread across more revenues.

Interestingly the price of the company is actually less than competitor Team17 (TM17) who are also cash-rich and owner-led. It could be said however that the potential for quicker growth lies with Frontier with their branded games. Personally I can see the case for buying, but its not an outright bargain. Instead I will watch this with interest. 3/5.

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