2023-07-20 17:43:59 ET
Summary
- Capcom's current share price I think is slightly expensive for new investors, a better entry point may come in the future.
- The gaming company can be seen as a potential acquisition target due to its successful franchises and new releases, following Microsoft's almost certain acquisition of Activision Blizzard.
- Despite risks associated with new IPs and potential over-reliance on existing franchises, Capcom's strong financial position and high return on invested capital indicate a positive long-term outlook.
Investment Thesis
I’d like to look at one of my favorite gaming companies these days, Capcom ( CCOEY ). Included is a brief outlook of what’s ahead for the company in terms of new games, historical financials, and my effort to come up with a reasonable price that I would be willing to pay for a long-term investment. Currently, it looks like the company is slightly expensive to own for a new investor and I would wait for a better entry point.
Outlook
Remakes
I got into Capcom's games back when Resident Evil 4 was released. I was just a wee lad and was very excited to play a horror game. It took me way too long to finish it because I was too afraid but once I did it, the game became my favorite game on the PS2. The game was revolutionary. The over-the-shoulder third-person perspective was adopted by many, many games ever since. The following sequels always left me with a sour taste in my mouth, especially the stuff after RE 6, which I don't even want to go into because that game almost killed the franchise. A revival of the series happened with the combining of the Japanese and the US version of the titles into one, Resident Evil Biohazard when they released the 7 th installment, and I loved it. It was back to the survival horror roots and less action-packed and a complete change in perspective, and it worked. RE Village brought me even closer to the feel of RE4, mainly because of the village part.
After the announcement of Resident Evil 2 Remake, I was very skeptical, but once I played the demo, I was very excited to play the full game and it didn’t disappoint. RE3 Remake on the other hand felt off, so when they finally announced RE4 Remake I was a little worried. Once RE4 was released, I was not disappointed. It quickly became so far 2 nd best-selling in the franchise , which I believe will surpass in the future, and it hit all of my nostalgic points.
So, in my opinion it is safe to say that the company is very capable of remaking its classic games and I am sure the company will continue to remake them because with the current tech of the new consoles, I would love to see what Dino Crisis or Code Veronica would look like. With such successes like RE2 and RE4, I don’t see the company abandoning this strategy any time soon.
An Acquisition Not Off the Table
I have to ponder the idea of an acquisition given that the company is around $8B market cap and the imminent acquisition of Activision Blizzard ( ATVI ) by Microsoft ( MSFT ). Sony ( SONY ) and MSFT have been acquiring many companies for a while now, and I think it is only a matter of time before one of these will look to acquire Capcom in the future because of the quality of games it makes, like the mentioned RE series, Street Fighter, Monster Hunter, and Devil May Cry. Not to mention the future games like the delayed Pragmata, which I was very excited about, and Dragon’s Dogma 2.
If an acquisition of ATVI will be passed, which owns one of the largest cash machines in the gaming industry (Call of Duty), I don’t see how Capcom, which is about a tenth of ATVI, wouldn’t be a target in the future.
Overall, I do believe that the company has a good future ahead, in terms of milking remakes further, and announcing more Resident Evil, Monster Hunter, and Street Fighter games. I’m sure RE games will start to get stale as they did in the past, and the team will have to go back to the drawing board to fix it all again. I am hoping that the eventual release of Pragmata will be good, which could be fantastic for the company because I think the way to grow is to take risks and create more IPs.
Risks
The company may start to not put as much effort into its existing franchises and repeat the whole debacle of cash grabs like RE6 and other low-rated spin-offs with the RE name attached to them, which will force them to reassess. This will lower profits and margins, and the company's reputation will suffer.
Taking risks with new IPs may prove to be disastrous and a waste of resources, for example, a delay in new releases is a good and a bad. The good is that the company seems to care about the quality of the game and wants to release a decent game, the bad is the game might go into a development hell and come out poorly optimized and not fun to play.
Financials
Just to note, all figures will be in USD because of the third-party compilation site I use for looking at companies’ financials and the FX rate might be different to what the company used, so the figures will vary slightly but still be around the ballpark. At the end of FY22, which ended in March '23, the company had around $764m in cash and equivalents, against essentially no long-term debt (only about ~$5m). This is a great financial position to be in, which provides a lot of flexibility for future plans, like taking risks on new IPs, acquiring some smaller developers, or continue making high-quality remakes.
I think that the current ratio has been a little too elevated for my liking. I would like it to be around 2 at max. At the end of FY22, the company’s ratio was almost 4, which may suggest that the company isn’t utilizing its assets very efficiently. It needs to be more proactive with the large cash position and make more new games, open more offices for those new IPs. At least this also tells us that the company will be able to cover its short-term obligations without issues if they all had to be paid at once.
Current Ratio (Autor)
In terms of profitability and efficiency, the company’s ROA and ROE are still really high. ROA could have been higher if the company used the cash which would make it even more efficient, however, ROA of 17% and ROE of 23% is very good. This tells me that the company is creating value for shareholders.
ROA and ROE (Author)
The company also has a very good return on invested capital. This tells me that Capcom has a competitive advantage in the industry and a strong moat, which I believe is true. I also like the fact that ROIC is increasing.
ROIC (Author)
In terms of margins, these are very solid already and I don’t expect to get more efficient than they already are. Maybe slightly better in the future with further tech advancements, but I am happy where the company is already because margins have improved quite a bit in the last 5 years.
Margins (Author)
Overall, I am liking how the company is operating. Slight inefficiencies in using its cash pile, but that’s hardly a bad thing. You can never have too much cash on hand, it’s not debt.
Valuation
In the last 8 years, the company averaged around 8% of revenue growth. So, for the base case, I decided to grow revenues at around 7% CAGR for the next decade, slightly more conservative. For the optimistic case, I went with 11.2%, while for the conservative case, I went with 5.5% CAGR for the next decade. I feel like these scenarios are all very possible and within reason.
In terms of margins, I mentioned that I don’t see too many improvements going forward, however, I can see over the next decade that there may be some slight improvements with further tech advancements, so for the base case, I decided to improve gross margins by 200bps and operating margins by 100bps over the next decade, which will bring net margins to around 34% by ’32.
Just to have a little leeway for my calculations, I will also add a 25% margin of safety to the intrinsic value, just to be even more conservative. With that said, Capcom's intrinsic value is $15.82, which suggests the company is currently expensive for my profile.
Intrinsic Value (Author)
Closing Comments
So, for my risk profile, the company is slightly too expensive and if I was to buy it right now, I wouldn’t get the best return in the future. The stock price has gone up over 60% in the last year and around 30% YTD, so the company’s share price was very close to my intrinsic valuation back in March. I might have missed the boat there now; however, I will keep watching it and following what happens in the future.
I would hold on to my shares if I was already an investor because the long-term outlook is intact. I would wait for a better entry point if I was looking to start a position in the company.
I believe the company has a lot of good talent for creating games in their current franchises and I believe new franchises will be money makers also, but that is just speculation. I’m hoping that Pragmata won’t take too long to release, along with Dragon’s Dogma 2.
For further details see:
Capcom: Wait For A Pullback, Long Thesis Intact