Estimated Reading Time: ~7 minutes
Square Enix is a $5bn market cap Japanese video game developer traded on the Tokyo Stock Exchange (TYO: 9684) and the domestic OTC markets (OTC: SQNXF / SQNNY).
I have been tracking the broader video gaming sector for some time. It’s in the midst of a consolidation boom – M&A activity in 2022 has already surpassed 2021, which itself set a record for the industry.
I believe Square Enix may be the next domino to fall in the sector. Consider these recent developments and the underlying fact pattern:
The Company is in the process of shedding underperforming non-core assets, a common tactic to “tidy up the house” prior to a sale.
It has been subject to takeover rumors in the recent past, denying speculation in 2021 (Bloomberg) and again hitting the rumor mill in 2022 (Forbes).
Its 74-year-old founder Yasuhiro Fukushima controls roughly 25% of its shares and may look to cash out after a 20+ year stint in the public markets.
In the absence of a transaction, its fundamentals look appealing:
It currently trades at a significant discount to peers despite leading topline growth and profitability metrics.
It pays a healthy dividend with a trailing yield of 2.2%.
And it has a debt-free balance sheet and a front-row seat to the secular growth story in video gaming.
In light of its recent divestiture, the Company has withdrawn forward guidance. But the data suggests it will be leaner, more profitable, and earn higher returns on invested capital going forward.
Video Game Consolidation Trend
“With three billion people actively playing games today, and fueled by a new generation steeped in the joys of interactive entertainment, gaming is now the largest and fastest-growing form of entertainment.”
There has been a land rush to secure gaming content, led by strategic acquisitions. Here are a few of the notable recent deals, segmented by transaction rationale:
Vertical Integration
Video game distribution behemoths Microsoft (Xbox and PC) and Sony (PlayStation) have been adding game development capabilities.
February 2022: Bungie acquired by Sony for $4bn
January 2022: Activision Blizzard acquired by Microsoft for $69bn
September 2020: ZeniMax acquired by Microsoft for $8bn
There are three primary distribution channels for video gaming content: personal computers, mobile devices, and video game consoles.
Microsoft’s Xbox and Sony’s PlayStation dominate the console market. Microsoft is also a key player in the personal computer market. Both have built ecosystems around their video game consoles: content subscriptions, digital stores, multiplayer services, etc.
Driving their acquisitive nature is the looming threat of platform exclusivity. For example, Sony’s PlayStation Studios develops games primarily for exclusive release on PlayStation. Microsoft’s new subsidiary ZeniMax will release its latest blockbuster exclusively on Xbox and PC. Microsoft may eventually pull Call of Duty and other Activision content from PlayStation, which are best sellers on the PlayStation platform.
Horizontal Expansion
Independent game developers are acquiring additional content and capabilities, primarily to accelerate growth in their respective mobile gaming segments.
January 2022: Zynga acquired by Take-Two for $13bn
February 2021: GluMobile acquired by Electronic Arts for $2bn
December 2020: Codemasters acquired by Electronic Arts for $1bn
Pure-play developers are feeling competitive pressure from the industry behemoths. Domestic developers like Electronic Arts and Take-Two were built on the back of console games. Now they are diversifying through M&A. After recent industry consolidation, there are not many independent AAA developers left standing. The question is, who will be next to get hitched?
Company Overview
Square Enix has a portfolio of leading intellectual property. Its Final Fantasy asset is 35 years old, with 16 titles released to date. And it’s more popular than ever. Other owned franchises include Kingdom Hearts and Dragon Quest.
While headquartered in Japan, this is a global company with the majority of its gaming unit sales coming from North America and Europe (77% in FY 2022). The Company’s core business is video games (“Digital Entertainment”), and it also operates an arcade segment (“Amusement”), publishes comics and books (“Publication”), and sells merchandise related to its intellectual property (“Merchandising”).
In 2009, Square Enix acquired the British video game publisher Eidos Interactive in an attempt to expand westward from its Japan-based development studios.
But in May 2022, it announced the sale of what was left of Eidos, ending its westward expansion attempt (it had already divested some European assets in 2017).
The Company has now come full circle after 13 years of disappointment. Although some of Eidos’ games were critically well-received, in general, the Western studios consistently underperformed commercially.
According to segment financials released in connection with the divestiture, the divested studios represented:
20% of Square Enix’s full-time employees,
7% of its net sales,
but only 2% of its operating income.
Not great. Reports indicate that it lost $200 million on two Marvel games developed by the divested studios.
It’s no secret that Japanese corporates often operate in a highly centralized manner. That likely didn’t help its subsidiary on the other side of the globe. But that’s in the past. Going forward, it will be a leaner, more profitable, and more focused organization.
Catalyst & Valuation
To reiterate: I think there is a strong possibility Square Enix draws inbound acquisition interest. Consider the circumstances:
It operates in an industry undergoing a massive consolidation wave.
It has been the subject of takeover rumors multiple times in the recent past.
Its founder controls ~25% of the company and may wish to cash out for retirement (the Company already repurchased some of his shares in 2017).
Last year, the Company denied receiving a takeover offer after speculation from CTFN and Bloomberg. Recent rumors suggest that its compatriot Sony might be interested (Forbes, Twitter). Indeed, Sony and Square Enix have a long-standing relationship. The companies have collaborated on multiple game releases, including timed exclusivity arrangements. Sony once owned 8% of Square Enix but sold in 2014 amid its own financial difficulties. Today, Sony’s fortunes have changed for the better, the competitive landscape has changed dramatically, and Sony has earmarked significant funds for M&A.
The Company continues to publish titles for Nintendo’s Switch and Microsoft’s Xbox. Microsoft has long tried to enter the Japanese market with limited success, so it might behoove them to acquire a Japanese studio to make inroads. The Company also announced a ‘strategic alliance’ with Tencent in 2018.
All of this to say, despite business conditions in Japan that make it difficult for foreign companies to acquire Japanese businesses, there are multiple potential strategic acquirers.
Industry Valuations (AAA Independent Studios)
Look at these peer trading multiples, growth, and profitability metrics.
Now go back and look at Square Enix’s revenue and EBIT margins over time.
Now, look at the peer trading multiples again. Make sense to you? Me neither.
I suspect the stock will get re-rated once it restores guidance ex-Western studios and its quarterly results demonstrate improvement in profitability (FYI, it’s currently trading at the lower bound of its historical valuation range). Peer valuation suggests there is as much as 50% valuation upside if it just trades in line with its domestic peers (Bandai Namco and Sega).
M&A transaction multiples in the sector are above 20x EV / LTM EBIT (Activision – 20.7x, Codemasters – 23.6x). Perhaps Square Enix should trade a discount to pure-play game development stocks, as its arcade business (12% of revenue) is more capital intensive. But a takeover at 15x EV / EBIT would represent a handsome payoff to equity investors at current stock price levels.
Risks & Conclusion
There are certainly execution risks – the Company could release a bad product for one of its flagship franchises or announce a value-destroying acquisition.
The yen is currently making multi-decade lows against the dollar. But the Company has been insulated, as it has few imports and serves a global market, with 77% of its FY 2022 unit sales coming from North America and Europe.
Square Enix owns industry-leading intellectual property. It has no debt, pays a healthy dividend, and trades at a discount to peers despite leading growth and profitability metrics. Its story has been simplified with the divestiture of underperforming non-core assets.
There is a massive consolidation wave underway in the video game sector. Will Square Enix be next? I suspect both Sony and Microsoft will be interested. The timing? Who knows, if ever. I certainly wouldn’t expect anything before the closing of its recent divestiture. After that, it will want to report a sufficient track record of results to get credit for its leaner structure before selling.
Please be aware that there is not much volume in the ADR. And I would be remiss if I didn’t remind you to consider the tax implications of investing in foreign corporates.
Thankfully, Square Enix has a great investor relations website, and all of the relevant news updates and filings are in English. Happy hunting!
If you enjoyed reading this Report, please do me the huge favor of simply pressing the “Like” button.
Just reply to this email to get in touch, or follow me on Twitter.
This article is not investment advice. The statistics and analyses herein are the author’s opinion and should not be relied upon as fact. Do your own diligence before making any investment decisions. The author retains the right to buy, sell or otherwise transact in any security without prior notice.