UBSFF - Ubisoft Entertainment: Market Outperformance Moving Forward

2023-06-17 04:10:23 ET

Summary

• I remain convinced and bullish on Ubisoft due to undervaluation, resulting in double-digit gains in less than 3 months and more going forward.
• The company faces challenges and a quick recovery is not expected in the next 1-2 years.
• Ubisoft's powerful brands and ability to create great products may help turn trends around.

Dear readers/followers,

Ubisoft (UBSFF) isn't really my favorite gaming company - and I happen to be a gamer - but it's a company that's at the very least worth looking at. In fact, as of my latest article, I went bullish and "LONG" the company due to the undervaluation. The position has outperformed since, and we're now at a position where I can report double-digit gains in less than 3 months - which is an excellent overall deal from an investment standpoint.

The company has plenty of challenges to work with. I don't foresee a quick recovery, not even in the next 1-2 years, but I do expect the company to slim down and turn the trends around, based on powerful brands in its portfolio, and proof that when the company puts its mind to it, they can actually make some very great products.

Ubisoft - Plenty to like about good gaming

I've mentioned before that calling Ubisoft a bad company doesn't really fly. It's a gaming company that has seen its share of trouble - even fundamental trouble - but to say that they no longer have an attractive portfolio, or an attractive set of assets is simply false. There is a lot to like about Ubisoft - and a far more appealing valuation than peers like Activision Blizzard (ATVI) is one of those things.

There are so many indicators that Ubisoft might in fact be on their way to turning things around, if they only got some of their "ducks" in a row. The company's customers and players, including myself, are waiting for the company to bring about another great game. For me, that includes something like Far Cry 5, which I view as one of the strongest in the entire franchise.

However, the real appeal that I see comes from clearly stating just how far the company has fallen. Ubisoft, in its native Paris ticker, trades at less than €26.5/share at this time. Despite this being up from previous levels and double digits, let me clearly state that implied valuations for this share based on forecasted EPS, book, FCF, P/S numbers, DCF valuation as well as simple historicals, point to an average PT or value of well over €40/share. You can then go ahead and discount/impair this valuation as you see fit - and there are plenty of reasons to do this.

There comes a time though, when you're impairing things too much - especially when we're talking about a company that manages some of the best gross margins in the entire industry. Its current profitability issues, while serious, are trends that I believe are likely to revert eventually.

Also, worth mentioning, the company despite all of these publicized issues, is still quite profitable - just not as profitable as we might want to see it being. It's true that debt has been rising, and currently stands higher than it ever has. But at the same time, the company has a quiet positive ROIC. It's also true that the shareholder equity portion of assets has gone from over 60% back in 2011, to less than 50% as things currently stand. None of those developments are positive, even if some of them can be explained by accounting and some temporary issues rather than more permanent ones.

The company reported full-year earnings for fiscal 2023 less than a year ago. Whenever they start the presentation with "while the past year was challenging...", you can assume that things are indeed going to be impacted in a big way.

At the same time, Ubisoft is reporting progress on several fronts. Let's see what we have here.

Top-line results, meaning bookings, were down 18% and are down to around €1.8B, just below. Digital revenues were down 11%, and back-catalog revenues were down 30%. At the same time, some of the companies strongest franchises had decent years in terms of activity and bookings.

Unfortunately, with the exception of Assassin's Creed, most of these titles and franchises are somewhat lackluster. In particular, The Division 2 is starting to not only get old, but player counts are dropping on a larger scale.

The company also had no real launches of import in Far Cry or any other franchises during this year. With a non-variable cost base, excluding all profit bonuses but including P&L structure costs, the company had costs of €1.75B. While this is lower than expected, it's really nowhere the cuts we need to see from the company - even with millions saved with tighter recruitment and favorable FX.

Headcount is down by 700, which is good, but at the same time, structure costs are up, Cash R&D spend is still growing. So the company doesn't yet have full control of all of its spending trends. On the other hand, estimates on a future basis are positive, and the company expects strong booking growth, strong growth in operating income, and finally some new releases in some of its core franchises.

My interest in mobile gaming as a gamer is zero, though I of course recognize the profit potential in such models and games.

Ubisoft remains a long-term turnaround potential, and the gaming industry is notoriously fickle to where I say that the only valuation where you want to buy any of the businesses in it, is at clear discounts. If you do that "right", then I believe your chances of making a profit are quite good.

Ubisoft adds to this complexity by, as I see it, not really having games that I am personally excited about in the same way as I've been about their previous ones - like AC: Valhalla.

Concerns in the financials are there. There is a steep sequential deterioration in net bookings growth, which also includes lower amounts of recognition in mobile licensing. The company's response to this is that it was simply a case of how these incomes were recognized - namely in the first three-quarters of the previous fiscal. There were also YoY positives from Dawn of Ragnarok and some other titles - yet the decline and slowdown in growth are really quite noticeable, and if it continues, it's something to keep an eye on. Ubisoft must, to put it simply, continue to bring products to market with less heads in its team and less R&D spend.

Second question, and this one's product-specific - Skull and Bones. The game has been in the works for several years, and every release or preview I've seen has been worse or less optimistic as I see it than the previous one. Now it seems to me that the game is actually being internally delayed due to what I construe as some serious issues where the company believes the game might "flop". I want to go on record here and say that I don't believe what the company is telling us and that I believe the game will not appeal to players - but we'll wait and see here.

Working capital outflows are bad - and I don't see any clear catalysts toward improvements beyond the company's already-active management and savings programs. The worrying part here is that WC was bad despite 2023 having no major releases. That's very atypical of a game company.

All in all, 2023 was not impressive - and my conviction is higher than 2024 is likely going to be better.

Ubisoft - A Better 2024 is expected, here is the valuation for the thesis

I characterized Ubisoft as a "speculative" company last when I wrote about it. That rating remains even after a double-digit RoR, which beat the market during the same timeframe back in April. On this perspective, the investment was a "successful" one.

What we want to see from Ubisoft is tighter capital control and better working capital, new title releases, and to put it in very frank terms, the company simply making some "better games". At the same time, such goals are hampered by the fact that the company is really slimming down, and when a company goes through the sort of journey that Ubisoft does, talent and leaders are usually the first ones who leave - because they can usually find better and more productive jobs elsewhere, which further upsets the organization and hampers the end results.

At the same time, Ubisoft is cheap. Very cheap.

On a 5-year basis, the company trades at 3.1x to sales on average. That number today is 1.5x, and that's with the impacted sales numbers we have. The native ticker trades at non-workable P/E numbers due to negative 2023A earnings, but are estimated to go positive again next year. The company's last few years were characterized by massive exuberance, which we shouldn't expect to repeat, especially not the way the company is going here.

Ubisoft, as you can see above, can warrant nothing more than a "speculative" rating. The reason that I am positive in this case is that I have a deeper understanding than most investors and analysts do about the ups and downs of these companies. Ubisoft will rise. My conviction about that is high. The question is how much, how high, and for how long, which will be determined by their commercial successes in 2024-2025. As I see this right now, the company doesn't have much to be excited about in the near term, which is why I'm not putting my PT's above €45, but at a conservative, long-term €40/share PT.

I'm not adjusting this target due to the full-year results either. Why? Because the assumption I work with already included the potential for this relatively poor 2023A, especially in terms of cash flows. Working capital was a bit of a surprise and a negative one.

The company's troubles are deep. But it is during times like this that bargains can be made - and like with most gaming companies, a huge part of the company's expenses are HR/Heads - those are, for this type of company, somewhat variable, and that is what the company is now cutting.

Ubisoft is in need of a renaissance on the corporate level. I don't see that happening just yet. But in the long term, I'm positive about this company and expect outperformance.

Based on this, here is my thesis for the company.

Thesis

• Ubisoft is, at least in theory, an attractive company with a good upside at the right price. However, due to what I would consider being mismanagement, the company's IP and pipeline don't really hold many products or games that I would consider likely to turn the currently unfavorable trends around.
• We haven't seen this turnaround for this 2023A fiscal, but I believe 2024E will be better.
• Ubisoft has a deep war chest, and I expect the company to eventually turn around. However, with the pipeline now updated and what'll happen in fiscal 2023-2024, it would further impair the company's valuation.
• I'm moving down 20%, and now consider the company a speculative "BUY" with a PT of €40 - no more.

Remember, I'm all about:

1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them ( italicized ).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

I would call it qualitative, inherently, and cheap as well as with an upside, but I wouldn't call it well-run or paying a dividend. For that reason, I call Ubisoft a "speculative BUY".

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