OTGLY - CD Projekt: Weak Phantom Liberty Adoption Could Pressure The Stock

2023-10-11 14:39:33 ET

Summary

• CD Projekt's stock is recommended as a hold due to a lack of positive catalysts and weak adoption of the Phantom Liberty expansion.
• The company's revenue growth is cyclical and volatile, with a major boost from the release of Cyberpunk 2077 in 2020.
• The attachment rate for Phantom Liberty is lower than expected, indicating lower market anticipation and potential decelerating sales.

Investment action

Based on my current outlook and analysis of CD Projekt ( OTGLF ), I recommend a hold rating. I expect the stock to remain rangebound in the near future due to a lack of positive catalysts and weak Phantom Liberty adoption.

Basic Information

CD Projekt is a business with two main parts: they develop videogames (the majority of revenue) and also distribute them. The business has a strong portfolio of video games that are famous in the gaming community. For example, they own Cyberpunk 2077 and The Witcher. CD Projekt is based in Poland but has 88% of its revenue from North America and Europe.

Review

Due to the nature of the business—developing video games—which faces “hits and misses”, CD Projekt's revenue growth has always been cyclical and volatile. The major breakthrough was when the business finally released Cyberpunk 2077 in 2020 (announced in 2012). This drove business revenue to extreme heights, reaching a total revenue of $2.1 billion in FY20. However, revenue saw a steep decline the following year, as the bulk of revenue in FY2020 was for the anticipated Cyberpunk 2077. Given that revenue for this demand is not recurring (one-off purchase), it is unlikely for the business to see a similar performance unless they come out with another mind-blowing and popular game or update. The recent result was another proof of the cyclicality in the business. The company's revenue dropped by 7% in 2Q23, leading to a 47% drop in EBIT. Since last year's earnings were so low to begin with, this year's drop is even more pronounced.

This brings me to my next point, where the fate of the stock price in the near term depends on how successful Cyberpunk 2077 Phantom Liberty is. Last week, management hosted an investor day dedicated to the results of the Phantom Liberty expansion pack. To give a quick summary, the presentation noted that 3 million copies were sold during the first week of launch; PLN275 million were expected for direct production expenditures and PLN95 million for marketing campaigns. In my opinion, investor day did not bring any positive surprises, and the stock should continue to face pressure as there are no immediate catalysts that will drive the stock up in the near term.

I think the major disappointment is that Phantom Liberty unit sales only reached 3 million by the end of the first week after the launch. Given the majority of sales are happening during the week ahead of the release, I believe the company should have no issues driving the figure higher than 3 million, mostly likely hitting 4 million units of sales by the end of 2023. On an absolute basis, this seems like a great accomplishment; however, it is weak when compared to the core game, Cyberpunk 2077. For reference, Cyberpunk 2077 sold 13.7 million copies in the first 3 weeks of release, implying 4.5 million per week on average, higher than the 3 million unit sales for Phantom Liberty. Moreover, taking into account the fact that the first week should see higher unit sales given the anticipation, the relative performance (Cyberpunk 2077 vs. Phantom Liberty) is further widened. This tells me that the anticipation of Phantom Liberty vs. Cyberpunk 2077 is much lower, which is very negative. The good news, I believe, is that around 20 million gamers have the main game, which supports the Phantom Liberty expansion.

The most important piece of information you've been waiting for is sales. Sales for the first week until the 3rd of October is 3 million copies. To contextualize this we estimated how many gamers have now the game, main game on PC or on the new consoles, all the platforms that allow you to play, it's 20 million, 20 million gamers who either have the main game or have updated the old gen to new gen version. CD Projekt Investor Day

Based on these figures, it implies a 15% attachment rate within 1 week after expansion. While management is saying that this is a great result, it is clearly not up to the market’s expectations given the stock's performance. Assuming Phantom Liberty has the same traction as the core game, the attachment rate should be somewhere in the 20 to 25% range (4.5 million to 20 million), which means there is a 500 to 750 bps delta.

In my opinion, CD Projekt's main issue is the way it creates games, which is why the studio is undergoing the RED 2.0 Transformation. Investors will remember that Cyberpunk 2077 had problems when it was first released in late 2020. The company used to operate under silo structures, where different groups were responsible for different aspects of the game, making it more challenging to bring everything together at the end. The shift to Agile by upper management to reduce the likelihood of production failure and increase transparency is, in my opinion, likely to pay off handsomely in the long run. Every member of the development team can now monitor the progress of the section of the game being worked on by his or her cross-functional team. Most importantly, this method guarantees that the game can be played at any point of the development timeline. The main advantage, in my opinion, is that the game can be released to beta testers rapidly, allowing them to start searching for bugs at an earlier stage in the development process. This greatly reduces the risk of early-game bugs becoming increasingly problematic as the game progresses, as happened in Cyberpunk 2077.

Nonetheless, I think the market is not going to give credit to this new approach, as the fact is that Phantom Liberty traction has been disappointing so far. Unless management can show that adoption will accelerate from the first week of data sales, investors are likely to extrapolate the weakness, projecting decelerating sales ahead. This also means there are no catalysts that would drive a re-rating in the near term. As such, I recommend a hold rating.

Valuation

I believe CD Projekt will see an acceleration in growth in FY23 due to the release of Phantom Liberty. Given the difficulty in accurately accessing how big the impact is given that we only have 1 week of sales data so far, I am anchoring my expectations against consensus estimates for FY23 (15% growth). However, for FY24, I expect the business to face a similar step-down in growth, just as it did in FY21. But the step down should be smaller, given that the increase is not as strong as the 310% growth. I modeled half the magnitude (~29% decline vs. 58% decline in FY21). Given that the business near term is now uncertain with no strong catalysts, I expect valuation to revert back to the pre-2H22 forward earnings valuation premium (~2x premium vs. the current 2.4x premium). I note that the valuation premium has climbed to as high as 2.8x at one point, which I believe is due to market expectations that Phantom Liberty was going to be a major hit; hence, I don’t think it is good historical data to use. Suppose the valuation premium reverts back to 2x, the stock should be trading at 32x forward earnings (peers trading at ~16x forward earnings).

Risk and final thoughts

The upside risk to my hold rating is that Phantom Liberty adoption starts to accelerate and beat market expectations significantly. This will likely cause a major upside revision in earnings expectations and valuation, driving the stock to new heights, which is also a main reason why I am not recommending a sell rating. However, based on the current data available, it is hard to make such an assumption. Hence, I believe the stock will stay rangebound in the near term.

In conclusion, I recommend a hold rating for CD Projekt based on the current circumstances. The company's performance has been influenced by the cyclical and volatile nature of the video game industry, with a significant portion of revenue coming from the one-time purchase of Cyberpunk 2077. The recent Phantom Liberty expansion has faced weaker adoption, and the stock may continue to be under pressure with no immediate positive catalysts in sight.

The disappointing sales figures for Phantom Liberty, compared to the core game, reflect lower market anticipation, and this, in my view, is a key concern. CD Projekt's transformation to a more Agile development approach may pay off in the long run, but it might not receive immediate recognition from the market.

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