OTGLY - CD Projekt: Phantom Liberty Alone Gets Us To 30x Run-Rate P/E

2023-06-07 11:56:33 ET

Summary

• CDPR's lumpy economics aren't the best in the gaming industry, but its titles might be, getting it to its lofty and aspirational P/E multiple.
• It's not an unreasonable multiple, as we calculate that Phantom Liberty alone likely gets CDPR to a 30x run-rate P/E for a little while.
• The problem is what comes after and when, since the Witcher Polaris project is probably a very long way off, and Sirius just got impaired with some discouraging management comments.
• We love the franchises but things can still go wrong. A couple more disappointing releases, even if the game ends up being righted later, could become a goodwill problem.
• Moreover, human capital turnover and other issues relating to labour in the sector are all potential issues. Finally, like fashion, brands can just crash.

CD Projekt ( OTGLF ) is probably our favourite gaming name to the extent that we are part of the products' demographic. But the economics are lumpy, and the valuation is high. We try to not turn up our noses at the lumpiness, because the reason for it is that the projects are creative, gestate for long periods of time and the business model isn't built on microtransactions - but the valuation does not leave much margin of safety. Phantom Liberty should be a great success, and we think that if it releases towards the end of 2023 as we've been led to believe, it alone gets the company to a run-rate 30x PE for a year or so thanks to a Cyberpunk sales steroid, before adding existing titles and the performance of Gwent to the mix. That's good, and is why the market is not getting it wrong as far as the company goes, but we still think that the distance between Phantom Liberty and another major title, probably the Witcher Polaris, is too big to justify the price that needs to be paid for the upcoming earnings curve.

Focus on Phantom Liberty ((PL))

Let's just briefly discuss Phantom Liberty. Based on how CDPR performed in the years when Blood and Wine was released, which was a year after the Witcher 3. There is more space between Cyberpunk 2077 and when PL may be released. Witcher 3 was also released in the middle of the year while CP was released around Christmas. We estimate that around 3.5 billion PLN in CP sales were made since its 2020 Christmas release. For the Witcher 3, about 3 billion PLN in sales were made in the 4 years after its initial release, and we think the shortfall from that period's overall revenue can be explained by expansion-related revenue from Hearts of Stone and Blood and Wine which could account for about 30% of the overall Witcher 3 sales over that period.

We think 2 billion in PLN sales are going to be spurred by PL in addition CP sales, based on the fact that it will be a bigger expansion than any before and 50% of the total CP revenue prior to the PL release will be added on as a tail. All these assumptions are based on pretty conservative price estimates for the games since we assume a lot of the sales are made on a promotional basis through Steam, G2A and other promotional schemes on consoles. 2 billion PLN in total PL revenue should have an average net income margin of around 35% (in release year it's always way lower because of rules on how COGS related to development is arbitrarily costed, where it's very upfront), and that income should come out over a couple of years, meaning that for a couple of years the run-rate contribution from just PL on CP sales could hold up a 30x annualised PE multiple all on its own. Then comes Gwent , which we think might account for 5% of CDPR's overall revenue (although Gwent seems to be dying based on management's plan to " hand it over to the community "), as well as residual sales on other titles like the Witcher games. Overall, for a couple of years after PL releases which will be like an almost new game, since B&W was almost a new game thanks to the volume of content it added, PEs will be more in line with industry standards around the 26x level approximately.

Bottom Line

The problem is that if PL releases this year (should towards year-end), we'll have about 2 years of gas at a reasonable multiple before something new would need to come out to justify those lofty earnings expectations. The Witcher Polaris project is probably many years away. They won't want to rush it again after the initial fiasco of the Cyberpunk release . Then there's the Sirius project, which has been impaired and management is 're-evaluating' it - so don't count on that even though it's eating up lots of resources. Some premium could make sense on CDPR but still.

Its titles are great, and they have pretty long tails, considering that more than 50% of the Witcher 3 sales happened after 4 years since its initial release. CP looks more upfronted due to growth in gaming and COVID-19 likely encouraging higher levels than normal of pre-ordering and excitement about a new release. It may not have as long of a tail, but it also may since the pie in gaming is bigger. The economics of CDPR make things really hard to predict, and release schedules, pre-order apprehension and lots of other factors also matter.

There are plenty of good and aspirational arguments as to why the current multiple makes sense, but we think things could go wrong and the multiple prices in an almost certainly to-plan progression on CDPR's projects, which go beyond just PL. There's just not such a great margin of safety in stocks like CDPR that anyone who games would know about, and have major Netflix series being made with their IPs.

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