Description

Gameloft SE (GFT FP), trades in Paris and is the leading independent worldwide publisher and developer of video games for smartphones, tablets and feature phones, deriving 56% of its revenue from iOS and Android platforms.  The company could see its stock appreciate 50+% over the next 12 months as operating margins see rapid expansion and the company begins to return cash to shareholders. 

Gameloft is based in Paris, but has 25 development studios and sales offices on 6 continents.  The company employs 6,240 people, about 5,200 of which are developers.  Unlike console based gaming companies like ATVI, Gameloft is not dependent on any one franchise – they have over 278 games on iOS alone with  60% of revenues being generated from owned IP.   The highest grossing game of 2012, Ice Age Village represented about 5% of revenues for the year.  The company is run by the founder, Michel Guillemot, who owns 13% of the stock with his family.  Incidentally, his brother Yves founded and runs Ubisoft Entertainment, a publisher of traditional console games.

Over the past few years, Gameloft has experienced several transformations in its business model.  The company was founded in 1999 and for the first 8 years only generated revenue from feature phones (java/brew)).  In 2007, the company began to develop games for smartphone platforms, such as iOS and later Android.  In 2010, smartphone sales represented 25% of the company’s revenue, and in the latest quarter of 2012, this was up to 56%.  They have been able to grow total revenues at an accelerating rate through this transition due to the continued growth in feature phones in emerging markets which has offset rapid declines of that business in the US and Europe.  Feature phone revenue growth has essentially been flat for the past 4 years, while smartphone revenues have grown at a CAGR of 80%. 

The second transition the company has executed on is transforming its smartphone revenue base from only selling premium games for anywhere between $0.99 and $7.99 to a business model based on freemium (free to play + in app purchases + advertising) and paymium (pay small amount up front ~$1.99 + in app purchases + advertising .  In the latest quarter, 67% of smartphone revenues were from in-app purchases and advertising, this is up from 30% in Q4 of 2011.

Smartphone & Tablet Market

As smartphones have become more powerful, with more storage and better displays, they are largely displacing handheld gaming devices like the 3DS (look at Nintendos’ recent report).  The selection of games within the Appstore or Google Play is pretty astonishing – over 150k last I checked in the Appstore.  There are clear winners and losers within this - while there are low barriers to entry into smartphone games, there a higher barriers to success and to profitability.   While there are certainly great success stories like Rovio, developer of Angry Birds who or Temple Run or OMGPop (Draw Something), the large majority of developers do not find this to be a very profitable business.  Gluu has been transforming its business from a legacy feature phone business to a freemium based smartphone publisher, but has yet to show any profitability in this phase.  ZNGA has fallen flat on its face since going public, largely because of a lack of innovation on mobile platforms.   Its acquisition of OMGPop has proven to be a disaster.  As Facebook users began to access Facebook through mobile platforms, ZNGA lost its customer base.  On the flipside, Gameloft has had positive EPS since 2009, and is now entering a period of significant margin expansion. 

Even more interesting for the gaming market has been the enormous growth in the tablet market.  While only introducing the iPad less than 3 years ago, with 121 million sold cumulatively, vs. 3x that number of iphones sold, the iPad represented 40% of Gameloft’s iOS revenue in Q4.  According to Flurry Analytics, 39% of daily time on smartphones is spent playing games, while 67% of time spent on tablets are spent playing games.  As lower cost android tablets proliferate, this should present a strong tailwind for Gameloft’s smartphone/tablet business in the next few years. 

iOS revenue generation has come sooner to the mobile market, than Android has.  Certain issues that have historically been headwinds to monetization, are beginning to subside.  While, every owner of an iPhone or iPad has given Apple their credit card information, this is not the case for Android and Google.  Buying an Android game often requires carrier billing, rather than direct billing from Google.  Many large carriers, such as Verizon and many in Europe have been reluctant to open up their networks for carrier billing, but that has started to change.  Additionally, fragmentation of the Android market has hindered smaller publishers from participating to the extent they could in iOS.  A developer only needs to port the game to ~5 devices for iOS (iPhone 4/4s/5 and iPad/iPad mini), while this number is many multiples of that for the Android environment.   There historically were more issues with subscriptions and in app purchases through Android, but that has all changed as well.  According to App Annie Intelligence, in December the industry saw iOS Appstore revenue grew of 35% and over 100% growth in Google Play store. 

Feature Phone Market

The feature phone market, while seemingly dead in the US, has remained robust in emerging markets.  According to Ericcson, there were over 6.5 billion mobile subscribers at the end of 2012.  Developed countries represent 25% of these subscriptions, with 122% penetration, while developing countries represent 75% of the subscriptions with 78% penetration.  Global subscribers are foreacasted to grow at a 5.4% CAGR from 2012-2016.  At the same time, smartphone penetration is only about 15% globally, although it’s around 70% in the US.  Gameloft remains a beneficiary of both global phone penetration as well as smartphone penetration.  The company derives 42% of its revenue from emerging markets, 31% from North America and 26% from EMEA. 

The feature phone market once saw a lot of competition prior to the advent of iOS and Android.  However, the scale needed to compete in this market is significant.  A company wanting to develop games in the US, would have to have all the carrier relationships, be put on the carriers ‘deck’, be able to port each game numerous times to the various handsets offered by the carriers ie:(( Carrier 1 x # of different handsets offered + Carrier 2 x # of different handsets offered …) in each country.  Gameloft operates in over 80 countries and has relationships with over 200 carriers.  Because of the scale issues, almost all of the competition, including companies like Gluu, exited the feature phone market, ceding it to Gameloft and EA.  Both companies essentially split the market share in this market globally.   In the early years of smartphone adoption, Gameloft kept feature phone revenue flat by taking market share, while in the past few years it has kept revenue flat by benefitting from increasing mobile penetration globally.  This revenue stream will decline over time, probably at an accelerating rate.  However, now that it is below  50% of revenue, the superior growth in smartphones has created a gentle landing as these revenues fall off. 

Gameloft

As mentioned before, GAmeloft as been transitioning from feature phones to smartphones and from Premium games to Freemium games while significantly increasing its R&D capabilities.  The company has reached a margin inflection point, which should drive accelerating EPS and FCF growth.  The company has some strong owned IP, as well as licensed IP.  Examples of owned IP are GT Racing, Asphault 6, Let’s Golf, Order & Chaos Online (MMORPG), Modern Combat.  Examples of 3^rd Party IP are Uno, Shrek, Ice Age Village, NFL Pro 2012, Brothers in Arms, The Dark Knight, Spiderman.  One interesting fact, that corroborates that this business is more about having a portfolio of games, rather than being sole hit driven, is that 65% of revenues in 2012, were derived from games published prior to 2012.  Below are the summary financials of the company:

Why is this investment interesting now? 

1)       Gameloft has been in an investment phase since 2009, hiring over 2,000 people in that period.  In 2008, EBIT margins ramped from 3% to 9%, as they had just finished an investment cycle in 2008, and over the past three years have stabilized around 12% through this investment cycle.  Top line growth has accelerated from 11% in 2009 to 27% this past year.   During the 1H Earnings call in September, the company announced that it had reached a level of stability in its R&D staff (75% of employees) for the next few years, and operating margins were primed to expand significantly.  During the last phase where the company pulled back on investment, margins expanded more than 900 bps. 

Over the last few years, the company has ratcheted up its development staff where they can  develop 30+ new titles / year, while continuing to improve upon the existing games out there.  Feature phones will begin to decline at a faster rate this year (they have been predicting this for the past 3 years, while it has proven more resilient), and will represent only about 36% of total revenues by the end of 2013.  The company has taken the preemptive move of cutting its feature phone staff in India that was dedicated to porting games.  So while it announced in September that it would hire about 100-150 people during 2013 (vs 800 in 2012), it revised that estimate on its Q4 Revenue call on 1/30 that it would in fact have a contraction in the development staff of a few hundred. 

2)       Over 10% of Gameloft’s market cap is in cash now, ~€46 million (company is debt free), and this should grow by over 50% by year end 2013.  Free cash flow grew over 90% in 2012, and should expand another 50% in 2013.  The company is discussing announcing its first buyback program sometime in mid year 2013.  This initially may take the form of a small buyback to offset dilution of stock based compensation, but over time may expand.  Any return of capital would be a big step for this company, and essentially minimize any fear the market has over additional large investments in the business, including M&A.

3)       Market consensus is finally conservative.  Despite the undemanding valuation of the company, the sell side analysts that cover it out of France, are particularly sensitive to small changes in consensus estimates of Revenue growth and Operating Profit margins.  Despite starting 2012 with a conservative consensus revenue of €180 million and finishing the year at €208, the stock did not perform well due downward revisions on operating profit margins because of investment in the R&D staff and discontinuation of console game development

Operating margin estimates started the 2012 at 15% with the company expected to report something closer to 11% in March.   Operating Profit margins optically look like they dipped from 12.8% in 2011 to 11% in 2012, however there was a change in their mix of game development, which impacted the reported figures.  The company started developing some console games in 2010, only to discontinue this a year or so after not seeing the desired results.  While the company expenses all R&D costs for mobile games up front, console games were capitalized and amortized over the life of the game.  In late 2011, they decided to exit the business, and accelerate the amortization of the capitalized R&D for console games that remained on the balance sheet.  This change from capitalizing €2 million of R&D in 2011 to amortizing over €3 million of the capitalized R&D in 2012, caused a swing of roughly €5 million.  Normalizing the numbers for an apples to apples comparison (expensing the figures in 2011 and 2012) would show a margin improvement over that period from 10.9% to 12%. 

Entering 2013, the street is looking for growth to decelerate from 27% to 15%, and for operating margins to expand from 11% (12% normalized run rate backing out console amortization) to 14%.  I have only modeled an expansion to 15% in 2013 and 18% in 2014.  However given management commentary about improving gross margins, and a relatively stable cost base (inflation in many of the countries Gameloft has studios in runs 5-7%), operating margins could be north of 16% in 2013 and 20% in 2014.  The company looks like it has entered a period where it can outperform both top and bottom line street estimates. 

4)       Growth in 2013 will likely be stronger than the 15% expected by the street.   Smart phone & tablet sales were up 90% in 2012, while the street is modeling for only 40% growth in 2013. 

• While the company has stated that they believe feature phone games could contract up to 10% in 2012, they were actually only down less than 1% in Q4.  The reason for the accelerated expected decline is that emerging markets are seeing an acceleration in smartphone penetration, negatively impacting feature phone sales.  This is actually a positive, as the company monetizes smart phone games at a much higher rate than feature phone games.   So the implication of slower feature phone growth, would be an acceleration in emerging market smarth phone growth.
• Tablets monetize at a much higher rate than smart phones.  Tablet penetration is substantially lower and growing at a faster pace than smart phones.  As more lower priced tablets enter the market, this should also increase monetization of the company’s growing MAU (Monthly Avg User) base of 80 million. 
• Increasing monetization of all smart devices.  The focus of the development teamas in 2013 is to optimize the portfolio of games.  Monetization of purely online games are much higher than that of offline games – 66% of games this year will be online only.  Social games provide the most recurring revenue per daily average user (DAU), and the company will have 14 of 31 games this year that are Social core games, up from 2 in 2012.
• Android is beginning to monetize at an accelerating pace.  Given the massive Android installed base as well as the relatively nascent tablet market, this only provides upside.
• Other platforms like Amazon Marketplace are growing at a very fast rate from a small base, but will begin to show up more meaningfully in numbers in 2013. 
• Market share growth – Gameloft’s smartphone revenues has been outpacing that of other large developers, taking more revenue share from the iOS and Android appstores.

 5)       While not core the thesis, Gameloft is a probable takeout candidate in the next few years.  They are one of only a few scale players in the mobile video game market, and given the undemanding valuation may look like an attractive candidate to companies looking to expand.  While a lot of the froth has come out of the M&A market in this sector since 2011, large Japanese players like DeNA and Gree have been very acquisitive in the past, and are still trying unsuccessfully to penetrate western markets.   DeNA acquired NGMoco, a mobile developer with $20-$30 million in revenues for $400 million in 2010.  In 2011, Gree acquired Openfeint for $104 million.  Famously, Zynga acquired OMGPop, developer of Draw Something for $200 million at ~4x revenues with no profitability.

Some of the traditional video game publishers have struggled to make successful inroads into the mobile game market, specifically Activision.  EA acquired Jamdat years ago, and later Playfish and Chillingo (publisher, not developer of Angry Birds), however has been ceding market share to Gameloft.  The mobile business of EA grew around 30% in Q4, 2012, vs. 67% at Gameloft. 

Valuation

Gameloft currently trades at €5.26, and could be worth could be worth somewhere between 7 and 8 over the next year.  What multiple you want to throw on this business, that is showing accelerating EPS and FCF growth on double digit revenue growth I will admit is rather arbitrary.  It is difficult to find any real comps - EA is showing ~15-20% EPS growth, and trades at 17x 2013 EPS and 14x 2014 EPS.  Applying these multiples, you would get a stock price between €6.50 and €7.70.  ATVI is showing a contaction on its top and bottom lines for 2013.  GLUU and ZNGA are having serious structural issues.  Transaction multiples would price this stock at some outrageous valuation that doesn’t make sense.  Simplistically, looking at the company trading at a premium to the 2014 market multiple of 14-15x on EPS, the company would be 50% higher.  You  get a similar results using a FCF yield of 6% on 2014 FCF/Share. 

Risks

• This is more of a growth idea, than a value idea and the forecasts are inherently less reliable.  The company may see all of its games do terribly during the year, and they will show growth that is materially weaker than the streets forecasts.  While I don't expect this to happen obviously, there is a risk of underperformance if its titles.
• The industry may move away from smartphone and tablet gaming
• Larger competitors like EA may become more aggressive in the market, and take share away from Gameloft
• The competitive nature of the business may drive down pricing of the monetization tools within games
• Policy changes at Apple and Google may negatively impact the revenue profile of the company.
• Feature phone revenue may decline at an accelerating rate worse than the 10% I have forecast.
• The company may decide it in fact needs more developers, and it begins to reinvest substantially in the business, hurting the margin expansion story. 
• The shares are not very liquid - they trade about  170k / day

Catalyst

• Expanding EBIT margins in 2013 as the company transitions out of an investment phase
• Company will have close to 20% of its market cap in cash by year end - expect a share buyback to be announced in mid-2013
• Conservative sell-side estimates setting the company up to outperform
• Increasing monetization within the portfolio of games and increase in tablet penetration driving higher monetization.
• New strong 3rd party IP to be launched in 2013
• Eventual takeout possible