OTGLY - CD Projekt RED: A Stock I'm Putting In The Madeleine Portfolio

2023-11-13 13:57:33 ET

Summary

• CD Projekt RED has the potential for significant growth in the gaming sector in the next 10 years, although with execution risk.
• The company's unique culture and focus on creativity have earned them a legendary reputation among gamers.
• Despite the initial setbacks with Cyberpunk 2077, the game has received high ratings and CD Projekt RED has learned valuable lessons for future projects.
• Future conservative estimates might indicate more than 800 million in sales for its next big hit, which means you're paying only 3x future sales.
• CD Projekt RED is definitely a takeover target for larger media or gaming companies.

Introduction

To put this article into perspective, let me give you some background. Recently I became a father. My first daughter Madeleine (a French name) was born on 11 September 2023. Since this happened, I started looking at the world differently and started thinking about some long-term stocks I want to put in my portfolio that I can then give to my daughter in 10 or 20 years. So these companies need to be either very future-proof and robust, or they need to have a lot of growth potential. Or preferably both. With this in mind, I started searching for companies that I know and love because I only invest in what I truly understand. And so eventually I arrived at CD Projekt Red (OTGLF) as one of the companies I'm putting in the "Madeleine Portfolio" as my play on the growing gaming sector. Let me explain why.

Before you continue: I strongly advise you to buy the Polish quote. Not the USA quote. There is way more volume in Poland. Ticker : CDR. ISIN : PLOPTTC00011.

Why put a gaming company into the Madeleine portfolio?

First of all, I love to game. I have been doing it on and off throughout my adult life. It's a great stress reliever for me and it's a great way to spend time with friends without having to go drinking or leaving the comfort of your home. It is also one of the hobbies you can spend thousands of hours doing while not ruining your bank account, as most games are free or cost very little compared to the entertainment value that they bring. Let's say you pay 50 USD for a game, but then spend 1000 hours playing it. That costs you literally 0.05 USD per hour to be entertained.

I also believe investing is something very personal. And what something is worth to you, is worth nothing to someone else. That's why I strongly believe you should only invest in things that you have a good sense of worth/value over. I know how much fun gaming can be and how much I would pay for a good game, so for me, the gaming sector is just super valuable.

And I'm not alone in this sentiment. Gaming will only become more and more popular in the future. Especially with the rise of the Metaverse and the ever-improving technology (better consoles, better gaming PCs, better graphics cards, better software). And not only better hardware but also at way more democratic prices.

This is also supported by data from Statista . In 2017 the gaming sector was worth 113 billion USD. By the end of 2023, it will be almost 250 billion USD and by the end of 2027, it will be worth 363 billion USD. In short: gaming is big business and will continue to grow in popularity.

Moreover, as a financial analyst, I see a lot of strength and interest in this sector. Traditional technology companies increasingly see the need to establish themselves in the gaming market to increase their competitive advantage. Just think of the acquisition of Activision Blizzard by Microsoft ( MSFT ) or Netflix ( NFLX ) launching a gaming department. In short: there is only a handful of interesting gaming companies listed on the stock market. And they get rarer every year. Last year Zynga was taken over by Take-Two Interactive ( TTWO ). And a year before that, Electronic Arts ( EA ) decided to buy Glu Mobile. You see what's happening here right?

The big boys in gaming are trying to increase their moat by acquiring smaller competitors. And BIG TECH is trying to absorb BIG GAMING companies to increase their moat. It's a vicious cycle. So that's one of the reasons why I want to be invested in a very talented but still relatively small company within the gaming sector: CD Projekt RED ( OTGLF ).

Why CD Projekt RED?

There are several good companies in the gaming sector, Electronic Arts or Take-Two Interactive for example, but since these companies are already quite "established", they have relatively less potential than a small gaming company that can become big. If CD Projekt RED grows from a 2.5 billion USD company to a 10 billion USD company, I book a +300% return (excluding dividends). If it only goes to 5 billion USD, you already book a +100% return. So I don't think it's that difficult to make a nice return here at current prices. If TTWO grows from 30 billion to 50 billion USD market cap, that's a 20 billion increase, you only make a 66% return. That's why investing in small or mid-caps can be so powerful for your total returns in the long term.

I'm not saying that CD Projekt RED doesn't have risks or that I'm certain that they will perform well. No, all I'm saying is that the odds here are probably in your favor here. Because I know the industry, I know the company, I know their product, and I have been following them for a long time.

And look, for me it's very simple. I think there is a higher chance that CD Projekt RED will double in the next 10 years than that the stock will be worth less than what it is worth today. I will explain why in this article. Also, CD Projekt RED is a clear takeover target for the bigger boys. There have been rumours already about Sony maybe wanting to acquire CD Projekt Red. So this is just an extra bonus and benefit of investing in a much smaller but very talented gaming studio: a takeover offer might be just around the corner.

Little bonus that might be helpful for the reader: I've visited Poland multiple times throughout my life and I love Eastern European people. The Polish people are called the "work horses of Europe" since they work so hard. So I have massive respect for their culture and strong sense of responsibility after they left the Soviet Union. They hate communism and they had to fight for their freedom/capitalism not that long ago. And so they love to work. And I believe that this gives this small Polish studio a hidden competitive advantage.

What makes CD Projekt RED so special?

Let's take a good look at the business model of the gaming sector because many people have the wrong idea that money is easy to make in this sector. But that's actually not true.

The gaming sector is very difficult . It is very difficult to make a good game, and it is even more difficult to get enough people interested in your game so that you make money from it (and preferably more than once). Moreover, many teams and different types of people have to work together on a game to make it a success. This makes management very important. And then we're not even talking about the creative decisions, where things can go wrong. In short: making a good game is 10x more difficult than making a film. And success is not guaranteed.

On the other hand, once you make a real hit, you can sell that game millions of times (indefinitely) and make huge profits. So it's a tough industry, but one that is very rewarding if you do it RIGHT.

So the fact that CD Project Red was able to sell more than 100 million copies of its two blockbuster franchises, should tell you something about this amazing studio.

The culture of the company: fighting to survive

This part is not crucial for the analysis of the company, but I might help you understand the company better and it will give you more perspective on the Polish grindset (mindset + grinding mentality).

In May 1994 Marcin Iwinski and Michal Kicinski started importing games from the United States and then resold them in Poland because there were few games available in Poland (due to the communist past). When Poland finally reached a normal economy, the official company was founded. The two comrades had barely $2,000 in their pockets at the time and were living in a friend's apartment.

In 1996, the two founders started to focus on importing and translating games: in short, selling games locally that were not made for the Polish market. And this was a great success. For example, the first game that was "localized" (Baldur's Gate from Bioware) became an immediate success, with 18,000 units sold.

Eventually, their interest in game distribution began to wane, and they started making games themselves, after hiring some talented developers. The two founders actually had no idea what they were getting into, but in 2002 they bought the rights to the Wied?min franchise (The Witcher) because they thought it was a cool story.

Finally, after more than a year of tinkering, they made a demo and showed it to major publishers in the hope that someone would help them with the game. But they were rejected everywhere. Moreover, no one was interested in Role Playing Games (RPGs). Most studios were focused on multiplayer games.

So they finally decided to go all in and do it themselves. They wanted to put the story of The Witcher in a game. Ultimately, 20 million zloty were invested in the project (about 5 million euros) and the development team was expanded to 100 people. The game was launched in 2007 and became a success (more than 1 million units sold). Then they made The Witcher 2 (2.2 million units sold) and then The Witcher 3 was released. This sold 50 million units. In the process of developing The Witcher games, they almost went bankrupt several times.

In short: CD Projekt RED has created its own success by believing in its own vision and product. And this has earned them a legendary reputation among gamers. In 2015 they won the Developer of the Year award.

Cyberpunk: history repeats itself

In 2016, CD Projekt RED started posting trailers on YouTube of a new major franchise they were working on: Cyberpunk 2077. The hype around this game started to increase, eventually increasing its stock price from 20 PLN to 443 PLN between 2016 and 2021. The rising popularity of The Witcher during this period also helped. But behind the scenes, there was actually a lot of chaos at the company and the development of the ambitious project did not go smoothly at all.

Cyberpunk was finally launched in 2020, in the midst of the pandemic, with many flaws. The game received very poor reviews, fans were furious, and the game was even temporarily removed from the PlayStation Store. A real shame. It was clear that CD Projekt RED had tried to complete an overly ambitious project in an unrealistic timeframe. The financial results were not bad (record figures were recorded), but the stock price fell from 400 PLN to 80 PLN.

But… it's now 2023 (3 years after release) and CD Projekt RED has continued to work on Cyberpunk 2077 in the meantime, the latest version of the game has received the highest and best ratings from all independent gaming journalists and CD Projekt RED saw its reputation restored. Cyberpunk 2077 is considered by many experts to be the new standard for Role Playing Games and is visually one of the best games in the world at the time of writing this article.

Moreover, CD Projekt RED learned a lot from the production of Cyberpunk 2077 (how to better approach big projects) and created a legendary game that will remain in mainstream culture for a long time. So, it is the second successful franchise, after The Witcher was launched. And this makes the gaming studio less dependent on the income from the Witcher games alone.

Cyberpunk 2077 has sold 25 million copies since launch. And this happened despite all the bad reviews and hate. But now the game is fixed and better than ever. So it's not that difficult to imagine that Cyberpunk 2077 could easily sell another few million units every year.

But what was the reaction from analysts after Cyberpunk 2077's latest major update and expansion? It cost 100 million euros to complete this. Analysts thought this was "too much money". And that caused the stock to fall. However, the analysts used to say the exact same thing about The Witcher 2. That this game "cost too much money". And then The Witcher 3 (the sequel) sold around 50 million copies.

So I think it is more important that as a gaming studio, you deliver quality, so that good word-of-mouth advertising is created than that you produce something "cheap" that ultimately does not get good reviews and no one wants to buy. Reputation is everything in the gaming sector.

The financials & future

When I tried to get this article published, the SA Editor told me to give EXACT PROJECTIONS on why CD Projekt RED would grow into a 10 billion USD company. But what this editor didn't understand is that CD Projekt RED is a gaming company. That means that the future success of the company is dependent on the launch of a handful of new and big projects that need to become massive hits. And guess what? All the projects are a secret. So it's impossible as an outsider to make quantitative predictions about projects we know nothing about.

What I can do though, is take a look at the historic performance of this gaming company and give some insight into how they are doing and what I think is going to happen. But forget the idea of "predicting the future" with small gaming companies.

And as we can see, revenue is going in the right direction. To keep things simple for the reader, I've put the revenue chart in USD and not in PLN, as this might be confusing.

In 2021 CD Projekt booked a record revenue of almost 600 million USD due to the launch of Cyberpunk 2077. And currently, they are doing around 220 million USD per year.

That's actually quite impressive if you see where they came from, in 2012 they were doing 40 million USD in sales. So that's a 5x. And remember: they don't do microtransactions like EA or TTWO. So that makes it even more impressive. People are actually buying old games from CD Projekt Red because they are THAT good.

And thanks to the successful relaunch of Cyberpunk 2077 (with update 2.0) and the release of the expansion pack (Phantom Liberty), I believe the studio could sell easily 5 to 10 million copies per year at a price of around 30 USD per copy, which could lead to 150 to 300 million USD in sales per annum as a minimum. Combine this with a strong Witcher Franchise that is staying relevant because of Netflix and mainstream media, and the studio could also sell a couple of million copies of this per year, while it's working on new projects. So the 200 million USD per year of sales seems very doable for the near future.

And since CD Projekt has historically been very good at keeping costs under control and staying profitable, I think the studio will be able to keep its sales steady, stay profitable, and finance itself in anticipation of its next big release. It currently has an impressive EBIT margin of 42%. The company also has 466 million PLN cash on the balance sheet, which is around 112 million USD.

So what's next for CD Projekt Red? The company is setting up offices in North America to work on its Project Orion, which is a mystery for now. But my guess is, because of rumors floating around the internet, that this could be a massive online multiplayer game in the Cyberpunk universe. A little bit like GTA 5. This could be a pretty epic way for CD Projekt to make a dent in the gaming universe and change its financial situation forever. Imagine they come out with a vast open-world Cyberpunk city, which they already built, but more interactive and with multiplayer possibilities, it could be GTA 5 moment for the company, just like how GTA 5 changed Take-Two Interactive forever.

Next to this exciting new Project Orion, CD Projekt Red already announced it is working on a new Witcher game, which could reignite the franchise to new heights. Plus, it's also working on project Hadar, a brand new franchise that we know nothing about so far.

So all in all, the future looks bright. CD Projekt RED has restored its brand value. And it has bought a lot of goodwill with gamers. Its next big hit might cause another record year, with possibly more than 800 million USD in sales (with fairly reasonable assumptions, if you see that they previously made a 180% jump from one big release to the next one). That would mean you're paying only 3x future sales for a growing gaming company with highly attractive intellectual property in a growing sector.

CD Projekt is a stock you want to accumulate not when all the good news is priced in (like in 2020). But when investors are afraid of execution risks and the development costs of new projects. Because in the next 10 years, CD Projekt might become a totally unrecognisable company, with (possibly) a massive multiplayer franchise and way more recurring revenue, which would derisk this investment massively. But of course, there are execution risks. That's why I'm not investing more than 5% of the Madeleine portfolio in this stock.

Technicals

I don't think that technical analysis is super important when investing for the long term. But from what you can see, the stock is now down 75% from its heights in 2020. And it has found support at the 75 PLN level and resistance at the 170 PLN level. The stock will probably move sideways for a couple of quarters before there will be action to the upside, probably triggered by news of new upcoming projects. So accumulating between 125 and 75 PLN seems to be a good strategy here.

Conclusion

CD Projekt RED is known as one of the most creative gaming companies in the world due to its pure focus on unique projects, great storytelling, and perseverance. Other gaming companies have billions in budget to make good games but make boring games with no new content. Just look at the new Call of Duty that yesterday received a 4/10 review from IGN.

In the meantime, CD Projekt RED creates the best creative, immersive games with a very limited budget. The company has grown through sheer willpower and creative vision. As an entrepreneur and gamer, I have nothing but respect for that. I played Cyberpunk 2077 myself, and for me, it's a really fantastic game, and I was repeatedly amazed by the quality and experience.

In short: as long as CD Projekt sticks to their rebellious identity and tells great stories, I think CD Projekt will continue to grow over time. The company has now 2 strong franchises in its portfolio and has a strong foundation from which it can continue to build.

What I also find positive is that the founders still own many shares in the company. Founder-led companies often create better shareholder returns than non-founder-led companies.

That's why I'm rating this stock as a long-term BUY. And if the price is weak, I will happily buy more below 100 PLN as well. I don't think the current market value of 2.6 billion USD is expensive for an emerging gaming studio with a lot of talent and unique culture and already 2 successful franchises.

Risks

Of course, CD Projekt is not a riskless investment. My biggest concern is the execution risk from the management team. Other risks include the potential failure of management to produce new franchises, lower sales than expected, and a Russian invasion of Poland. The gaming sector is also highly competitive. Always do your own research before investing and only invest what you are comfortable losing.

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