CCOEY - Capcom Is Fairly Valued Despite Recent Price Correction

2024-01-05 13:52:14 ET

Summary

• Capcom's stock price declined by -14% in the two months after its latest quarterly results announcement, as the company's Q2 FY 2023 performance fell short of expectations.
• But Capcom trades at slightly above 1x PEG, which implies that the stock's current valuations are unappealing.
• I have a Hold rating for the Japanese gaming company; Capcom's long-term track record is very impressive, but its short-to-mid term prospects are unexciting.

Elevator Pitch

I assign a Hold investment rating to Capcom Co., Ltd. ( CCOEY ) [9697:JP].

Capcom's shares have dropped by roughly -14% in the last two months or so, and this is justified by the company's weaker-than-expected quarterly results and its poor financial outlook. I deem Capcom stock to be trading at a fair valuation based on the Price-to-Earnings Growth or PEG metric. As such, I have a Neutral view and Hold rating for Capcom.

Readers should note that they can buy and sell Capcom's shares on both the Tokyo Stock Exchange and the Over-The-Counter market. The mean daily trading values for Capcom's OTC shares and Japanese shares were $150,000 and $40 million, respectively for the last three months according to S&P Capital IQ data. Investors can rely on US brokerages like Interactive Brokers to trade in Capcom's shares listed in Japan.

Company Description

In its corporate fact sheet , Capcom describes itself as "a game software developer based in Osaka", Japan.

A Snapshot Of Capcom's Key Businesses

Capcom refers to fiscal 2023 as the financial period between April 1, 2023 and March 31, 2024. In 1H FY 2023, CCOEY generated 82%, 12%, 4%, and 2% of its revenue from the Digital Contents, Arcade Operations, Amusement Equipment, and Other Businesses segments, respectively as disclosed in its recent second quarter earnings presentation .

In terms of the company's geographic exposure, Capcom revealed in the company's 2023 Integrated Report that the company's games are sold in 230 markets globally.

Capcom Has An Impressive Long-Term Track Record

Capcom boasts an outstanding track record for the long run with respect to both its share price performance and financial results.

Based on historical stock price data taken from S&P Capital IQ , Capcom's Japan-listed shares rose by +601.8% in the past decade, which is equivalent to a 10-year CAGR of +21.7%. The company's stock price outperformance is supported by the excellent set of results that it has delivered. According to its disclosures in the 2023 Integrated Report, Capcom registered a +17.5% operating profit CAGR for the FY 2012-2022 financial period.

There are multiple factors contributing to Capcom's long-term success.

One factor is the company's "single content multiple usage" approach.

On the company's website , CCOEY highlights that its "popular original content is used for home video games as well as for character merchandise, movies and many other uses in order to maximize earnings." For example, there have been seven movies based on Capcom's Resident Evil IP thus far with the first one in 2002 and the most recent film released in 2021.

Another factor is the longevity of Capcom's games or intellectual properties.

The company mentioned in its 2019 Integrated Report that it has "20- and even 30-year-old IPs." It is worthy of note that Capcom typically derives a relatively low 30% of its current year revenue from new games introduced to the market in the same year. This means that the vast majority of CCOEY's sales are generated from "old" games.

The final factor that can't be ignored is Capcom's international expansion efforts.

Earlier in this article, I touched on the fact that CCOEY's games are available for purchase in as many as 230 markets. Capcom continues to expand its presence in markets with huge growth potential. As an example, a September 25, 2023 article published in The Japan Times indicated that Capcom has the ambitions to grow significantly in India. As it stands now, CCOEY's annual sales for the Indian market is roughly 100,000 units, but the company is targeting to deliver two million unit sales in India in the next 10 years.

In summary, Capcom's shares and business operations have done well in the last decade for valid reasons. But there is no assurance CCOEY can record similarly robust operating income growth and substantial capital appreciation in the future as detailed in the next section.

But CCOEY's Recent Quarterly Performance Disappointed The Market

Capcom's actual EBITDA and EBIT decreased by -56.7% QoQ and -59.3% QoQ to JPY10.8 billion and JPY9.8 billion, respectively in the recent second quarter of fiscal 2023 (July 1, 2023 to September 30, 2023). The company's Q2 FY 2023 EBIT and EBITDA turned out to be -18.4% and -14.3% below the sell-side analysts' consensus financial projections, respectively as per S&P Capital IQ data.

Both the company's OTC shares and Japan-listed shares have fallen by approximately -14%, respectively in the two months since Capcom disclosed its Q2 FY 2023 financial performance on October 26 last year. It is natural to assume that the market was dissatisfied with Capcom's latest results.

CCOEY's short-to-medium term financial outlook is uninspiring. The market sees Capcom's EBIT growth (in JPY terms) moderating from +25.6% (estimate) for FY 2023 to +14.3% and +8.9% for FY 2024 and FY 2025, respectively.

In my opinion, there are a couple of negative factors that are responsible for Capcom's below-expectations second quarter earnings and its lackluster financial prospects.

Firstly, Capcom's recent "hit rate" with new game developments is likely to have been inferior to what it achieved in the past.

At the company's Q2 FY 2023 earnings call , Capcom stressed that "not all the investment we make into game development" will definitely "bear fruit given the creative trial-and-error process of making games." This explains why CCOEY's Digital Contents business segment recognized a JPY3 billion impairment in Q2 FY 2023. Also, the company cautioned that it might suffer from similar impairments for the second half of the current fiscal year. It is not unusual for gaming companies to have a "poor run" when a higher proportion of game investments don't translate into tangible results, and this might be the case with Capcom for now.

Secondly, it is highly probable that CCOEY is earning relatively lower profit margins on its "old" games now as a result of an increase in price optimization initiatives to boost revenue.

Capcom noted at its second quarter earnings briefing that it "will ramp up pricing promotions" in 2H FY 2023 to "continue growing unit sales, especially for our back catalog." This seems to send a signal that the company has to be price competitive to drive meaningful unit sales growth.

Lastly, the company hasn't adapted to the rising popularity of mobile games, and this could have hurt its growth potential.

In the September 25, 2023, The Japan Times article referred to above, Capcom's COO Haruhiro Tsujimoto was quoted as saying that "traditional free-to-play smartphone games are not a good fit" for CCOEY.

It is also noted in this The Japan Times news article that the company intends "to license content to others", rather than develop free-to-play mobile "games on its own. However, CCOEY indicated in its Q2 FY 2023 results call that the royalty income contribution for the game Monster Hunter (which has been licensed to mobile gaming company Niantic) isn't likely to be substantial in 2H FY 2023.

In other words, it isn't easy for CCOEY to make the transition to mobile games, and the licensing model might not contribute significant earnings as compared to developing games on its own.

Concluding Thoughts

Capcom's valuations aren't sufficiently attractive yet, although its share price has corrected since the release of its Q2 FY 2023 results. The market is now valuing Capcom at a consensus current fiscal year P/E multiple of 22.0 times, while its consensus FY 2022-2024 EPS CAGR forecast is +20.3% (source: S&P Capital IQ ). In other words, Capcom is currently trading at 1.08 times PEG (Price-to-Earnings Growth), which is close to the PEG of 1.0 times indicative of fair valuation.

My rating for CCOEY is a Hold, taking into account its current valuations, historical financial performance, and short-to-intermediate term prospects.

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