2023-06-28 11:20:54 ET
Summary
- Capcom has incredibly good margins, boasting an EBITDA-M of 43%.
- Revenue has grown well and is accelerating as its game pipeline improves.
- We believe there are numerous industry tailwinds that will support further growth in conjunction with new game releases.
- The Street Fighter 6 release could supercharge the current year.
- With a significant share price rally, we suggest caution.
Investment thesis
Our current investment thesis is:
- Capcom (CCOEY) is an impressive business. It is a market leader for margins and its growth is healthy.
- We believe the company can continue its current trajectory, although is highly dependent on the development of engaging new games.
- Its investment in people and track record of well-reviewed games alleviates much of the concern in this regard.
- Capcom's share price has made significant gains in recent years, currently leaving no upside.
Company description
Capcom Co., Ltd. develops and sells video games, mobile games, and arcade games internationally. Its primary franchises are Resident Evil, Street Fighter, and Monster Hunter.
It operates through the following segments:
- Digital Contents develops and sells packaged and digital game content for consumer home video game platforms, as well as mobile content and PC online games.
- Arcade Operations operates Plaza Capcom amusement facilities primarily in commercial complexes, as well as hosts various event
- Amusement Equipments is involved in the development, manufacture, and sale of frames and LCD devices for gaming machines, as well as software.
- Other Businesses engages in adapting game content into movies, animated television programs, music CDs, and merchandise; and devoting resources to esports. It also manages amusement arcades.
Share price
Capcom's share price has performed incredibly well in the last decade, as financial improvement has driven increased shareholder value consistently YoY.
Financial analysis
Presented above is Capcom's financial performance for the last decade.
Revenue & Commercial Factors
Capcom's revenue has grown at a CAGR of 3% across the last 10 years, with relative consistency throughout the period. There is a degree of lumpiness, driven by the timing of game releases and their success. Overarchingly, revenue has developed positively and at an increasing rate in recent years.
business Model and Competitive Positioning
Capcom's focus has been on the development of video games playable on various platforms, primarily utilizing its key IP. In recent years, its focus has been on Resident Evil and Monster Hunter, with great success from both. The company's competitive position in the market revolves around the continued success of these titles, many of which are internationally supported by a loyal fanbase.
Given the firm's relative size in the industry, Capcom's objective is to create engrossing and timeless games, which positions them to sell successfully for several years. The alternative to this would require significantly more resources to repeatedly create new games. As the following illustrates, its last 9 major releases have had long sales tails that continue years later.
With this in mind, Capcom's approach to game development is one of care and intense focus on quality, which some of its peers have lost sight of in recent years given the heavy pressure to pump games out regularly. We believe the company's culture fosters such an environment, with its game reviews showing the results. The most recent Resident Evil 4 release has a 10/10 rating on Steam and has sold incredibly well (for a remake).
Although the business operates 4 distinct divisions, it generates c.78% of its revenue through its Digital Contents segment, with the other departments utilizing the same IP. This gives the business some diversification benefits but it is nevertheless highly influenced by the success of new game releases.
Management's approach to achieving long-term growth involves employee development. Given the importance of successful game development, Capcom is highly committed to the development of its staff, both for retention and quality service. In the most recent period, Capcom increased the average annual salary of permanent employees by 30% (and is linking compensation to performance), as well as introducing a stock-grant program. With most businesses seeking to cut costs while also maximizing productivity, it is impressive to see a company focus on its employees successfully. Capcom's margins have been consistently improving (which we will discuss later), allowing for reinvestment in its people, with the intention to create a circular outcome.
Further, Capcom is investing in the strengths of its core IP, with in-house movie production, e-sports activities, and sponsorships. We believe this is critical to the continued success of the business as it alleviates some of the pressures placed on the game development team (bad games can still sell well). Street Fighter 6 was recently released and has already achieved a record level of sign-ups for upcoming tournaments . Given the recent success of the Super Mario movie ( OTCPK:NTDOY ) and the hype around Barbie ( MAT ), we believe movie production, in particular, could be a lucrative avenue. A revival of the Resident Evil franchise potentially?
Finally, Capcom is seeking to build out its related services, such as Arcade Operations and Amusement Equipments, in conjunction with the growth of its game sales. This is the one strategy we do not really understand. Not only are Capcom's other departments significantly smaller in size, but they are also far less profitable. It does not make sense to dilute earnings unnecessarily.
Related to the point above, we are surprised to see the company does not specifically mention the desire to focus on the development of new IP. Scale through new games, as well as the diversification benefits, seems the best course of action to grow long-term. We much prefer this to expanding other departments.
Gaming Industry
Having covered several businesses in the gaming space previously, we reiterate that the biggest trend in the industry is the exponential growth of mobile gaming. Owing to technological development, the quality of mobile games has rapidly increased. This has significantly increased the total addressable market, as many more "casual" consumers are now introduced to the market. Further, businesses are able to release mobile versions of their games, thus selling more to the same audience. Capcom has dipped its toes into the market but we believe there is still significant scope for further expansion. A new Monster Hunter game is expected to launch in Sept23, which will immediately bolster its offering.
In addition to the above, we consider monetization to be a key development in the gaming industry. Innovation on the pricing side has allowed businesses to generate ongoing revenue from existing games, through microtransactions and follow-up content. The scope for this is greater with mobile games, which is one of the reasons we consider it such a lucrative segment. Once again, Capcom is developing its monetization model, which is currently weighted toward new content (Rumors are of a new RE4 DLC soon). We believe there is sufficient opportunity for increased microtransactions, such as through character cosmetics.
Finally, the rise of Virtual Reality is quickly becoming a potential avenue for high growth in the coming years. Apple's ( AAPL ) entry into the market and Meta's ( META ) significant investment alone will continue to encourage game developers into the market. Capcom has developed Resident Evil games in VR and is rumoured to be working on a RE4 version. Capcom's approach to porting Resident Evil Village is described as follows.
Capcom spared no expense for the VR port of Resident Evil Village, implementing hand controls, foveated rendering, and haptic elements, as well as refining the color scheme to make the game world look as authentic as possible when seen through the headset's lens.
This again illustrates the company's commitment to a quality experience.
Margins
Capcom has achieved impressive margin improvement in recent years, with an EBITDA-M of 43% and a NIM of 29% in FY23. A degree of this is the capitalization of expenses but even when this is included, Capcom boasts an impressive level.
This has been driven by greater sales of high-margin games, rapidly contributing to a product mix change. With the increased momentum these titles have, we believe an EBITDA-M >35% looks reasonable.
Management is impressively forecasting operating profit growth of 10%+ in the coming years, which likely outstrips revenue, implying further margin growth. This looks slightly optimistic given the business is targeting improved scale, which may come at the cost of margin.
Industry analysis
Presented above is a comparison of Capcom's growth and profitability to the average of its industry, as defined by Seeking Alpha ( 17 companies).
Growth is relatively comparable to the market, although slightly lags when extending to a 5-year period. Importantly, the growth in profitability is far higher.
Not only are Capcom's margins impressive on a standalone basis, but they are also market-leading. Its EBITDA-M is almost double the average of the 17 companies and is 11% higher than the next closest business.
Valuation
Capcom is currently trading at 19x LTM EBITDA and 16x NTM EBITDA. This is a significant premium to its historical average.
A premium is unequivocally justified given the higher margins, improved global awareness of its brands, industry tailwinds, and scale. The degree to which is the question that needs answering.
Given the substantial margin superiority over peers, we have conducted a DCF valuation of the business. Our key assumptions are:
- Continued strong growth (5-10%) as the pipeline of games increases. We expect Street Fighter 6 to be fairly successful based on internet hype (9/10 rating on Steam), expecting heightened growth in FY23.
- Conservatively, we have purposefully forecast margins to remain steady, before slightly tailing off. Although we believe the current levels are sustainable, it is difficult to not see some erosion with scale.
- An exit multiple of 15x, reflecting its superior margins but offset by the concentration of its current IP.
Based on this, we derive an upside of 5%, implying the company is running slightly hot. This does have one key weakness, which is how successful the Street Fighter 6 game is.
Final thoughts
Capcom is truly a hidden gem. Management has quietly transformed the business, built on the back of quality product development. Our expectation is for this to continue, as Capcom invests in its employees further, ensuring retention.
Although we see scope for growth improvement, we believe a gradual increase in the number of games released will support this trajectory.
With the monumental share price increase in recent years and the share price at an all-time high, we believe the company is now at its fair value. We suggest caution.
For further details see:
Capcom: Incredible Business Running Slightly Hot