CD Projekt: Taking the company to the next level?
CD Projekt: Taking the company to the next level?
Summary
CD Projekt is a conservatively run company with a cash cushion, no debt, and a high return on equity which is a good position to be in in the current markets
It has some great IPs and deep knowledge of building complex action RPGs that give them an edge
The new strategy by the management team is very ambitious where triple-A titles need to be released at a higher frequency in the future
Ambition does not equal execution so the proof of the pudding will be in the eating
I consider CD Projekt a great company but overvalued at the moment by the market. Costs will substantially increase in the short term to fuel future growth
Company History
The founders started the company in 1994 as a polish publishing company for games (video and board games), as a result in 1999 their first full-fledged localization of games into Polish. The first video game they localized was coincidentally one of my favorite video games of all time: Baldur’s gate. They sold 100 000 copies, a huge success.
2002 marked the year of the birth of CD Projekt RED to make their own video games. They licensed The Witcher IP and started developing the first Witcher game in 2003. Four years later, the game was released with success.
The online distribution platform GOG.COM came into play in 2008. (Steam from Valve was released in 2003). The Good Old Games distribution platform was initially focused on reviving old classic games.
In 2011, CD Projekt SA went public on the polish stock market through a merger with another company called Optimus SA. Optimus did no longer have any noteworthy business activities.
In the following years, CD Projekt RED used its resources to develop two others games in the Witcher universe.
The Witcher 3 Wild Hunt released in 2015 was a huge success with multiple awards and great sales even in the following years. Their latest release at the end of 2020, Cyberpunk 2077 set in the popular Cyberpunk IP created by Mike Pondsmith, while financially a huge success, was heavily criticized. Expectations were not met; the console versions were especially unplayable at the start.
CD Projekt overpromised and underdelivered.
Since then, the company has been fully dedicated to ‘fixing’ the issues and after releasing several patches in addition to the release of a critically acclaimed anime series on Netflix called Cyberpunk Edgerunners, Cyberpunk 2077 has somewhat recovered from its disastrous launch.
During the year 2021, CD Projekt acquired The Molasses Flood, a US-based game studio that developed 2 games in the past: The Flame in the Flood, a survival game, and Drake Hollow, a build and defense game with online co-op play.
In March 2021, management released a strategy update to explain the lessons they have learned and how they want to move forward. This strategy was again updated recently in October 2022 to give a longer-term outlook for the company.
How do they make money?
Here’s an overview of their business model:
Essentially, they develop and publish their games. Through GOG.COM they digitally distribute their own games and those from other publishers directly to gamers.
They make money in mainly two ways :
Their online distribution platform GOG.COM where they take a margin as a distributor for each game sold
The sales from their in-house developed video games, which are sold in physical form and digital form through GOG.COM or other digital distribution platforms
Their biggest market is by far the US, which accounts for about 75% of total sales volume.
Headquarters are situated in Warsaw, Poland but as can be seen on the map, a part of the staff and development teams are spread out over the world.
The CD Projekt group consists of :
GOG.COM – a digital distribution platform for PC games
CD Projekt RED – a game development studio and publishing company
The Molasses Flood – a US-based game development company acquired in 2021
When looking at revenue for the group, the company has an era before 2015 and after. Note that the data for 2022 is extrapolated based on H1 2022 results.
Before 2015, revenue was dominated by the distribution of games through GOG.COM. The three numbers shown coincide with the release of The Witcher, The Witcher 3 Wild Hunt, and Cyberpunk 2077. Due to the huge success of the Witcher 3, CD Projekt is now mainly a game development and publishing company. The distribution of other games is still part of the business, but the success of their games far surpasses that.
The company develops and prepares for a big release of a game. The year of release marks a sharp increase in revenue. The years after the release show a tail where revenues will drop year by year, until the next release. This cycle repeats itself.
CD Projekt is not a cyclical company based on the classical definition that it does not follow a macroeconomic or commodity pattern, but it shows a cyclical behavior in its financial numbers due to the nature of its business.
The current cycle length is about 5 years. Between those big releases, they do patching of their released games, release expansions of these games, and develop the next upcoming game in the pipeline.
A so-called long tail can be observed after each release, a big spike in sales and then a decline in the following years. As is typical in the video game industry, while the Witcher 3 may have cost 50 USD upon release, the entire game with expansions is now available for 8 to 10 USD.
The Witcher 3, looking at unit sales, had a very strong long tail. Normally you would expect after 2018, a decline, but the sales were boosted by the release of the Witcher TV series at the end of 2019. 2021 was reported as the best year for sales in terms of unit sales since the initial release of the Witcher 3 Wild Hunt in 2015.
The Witcher has solid longevity in unit sales versus Cyberpunk which sold massively upon release but without the same breadth or depth afterward.
During the last strategy update in October 2022, CD Projekt stated that Cyberpunk 2077 has now achieved 20 million in sales in total.
The business model is therefore pretty straightforward: Sales come from selling games. Costs are related to salaries, buying licenses (Unreal engine or IPs) or other needs to develop games, marketing, and outsourcing. There are currently 493 people working within CD Projekt RED but more than 600 to 700 people are outsourced to develop their games and operate the business.
GOG.com is a distribution platform for PC games. Game developers or publishers can sell their games through GOG.COM which will take a commission. The biggest player in the PC digital distribution market is Steam (from Valve). Based on the annual reports, CD Projekt group has never really made a profit/loss with gog.com. GOG.COM adds a small diversification to the business model. When their games are sold through Steam, steam takes a 30% commission. A part of this can be avoided by sales that are generated directly through their platform.
A flywheel in other media is used to increase the longevity of said games.
You can see this when looking at the current player count for the Witcher 3.
The player count today is higher than at the end of 2016 which speaks to the popularity of the IP.
We see the same thing happening for Cyberpunk 2077 upon the release of the Edgerunners anime.
The big spike upon release speaks to the marketing campaign’s success because the number of downloads and installs was 10x what the Witcher 3 was in 2015. When we zoom in a little.
The impact of the Edgerunners anime becomes visible.
An increased player count of course does not equate exactly to all new sales, but some of them are. The investment in alternate media publishing on the same IP leads to a strengthening of the long tail after the initial release.
Now that we have a better idea of how sales are generated, let us first take a look at their competition.
In which industry are they playing?
The gaming industry as a whole is very competitive. It can be divided into different parts. CD Projekt develops gamer’s games. In particular, triple-A role-playing games (RPGs) where you play from the first or third person. Past games from other developers that fit into this category are :
Fallout and Skyrim by Bethesda Softworks (acquired for 7.5BUSD by Microsoft in 2021)
Mass Effect or knight of the old republic by Bioware (acquired for 800 MUSD by Electronic Arts in 2007)
Other games like Final Fantasy (Square Enix), Red Dead Redemption (Rockstar Games / Take-Two Interactive or the Outer worlds (Obsidian Entertainment)
Here’s a sample of the size of these publicly traded game companies based on annual sales revenue.
CD Projekt is small in comparison to these bigger companies, but it wants to become bigger. I mentioned that several companies were acquired in the past by bigger ones. There has been some rumor in the past of CD Projekt potentially being acquired by other bigger companies. Management has reiterated several times that they want to remain independent.
The following graph provides an overview of unit lifetime sales for similar games released in the same period as the Witcher 3. The Witcher 3 has been sold 40 million times. Fallout 4, Skyrim, and The Witcher are similar games. They are single-player action RPGs that allow for deep character development and adventure in an open world. Grand Theft Auto V has been added for comparison purposes. It differs from these games being a bit more casual, being online, and having a more broad theme.
The target audience of a game is important:
The Witcher 1 -> pure RPG game -> appeals to a specific audience
The Witcher 3 -> RPG game with developed action elements -> broadens the audience a bit
Cyberpunk 2077 -> RPG game with action and shooter elements -> bigger audience
Grand Theft Auto -> Action game with RPG elements -> huge audience
Grand Theft Auto online -> Same as before but the online element brings longevity to the game
CD Projekt understands this. Here’s a picture from their march 2021 strategy update. I’ve modified the online part.
Management has said that online elements will be added in the future to all IPs. But we should not expect something like Grand Theft Auto V.
Does CD Projekt have a clear MOAT?
In 2020, 9512 games were published for personal computers. But you’re lucky to find one or two triple-A action-RPG in there. They are fishing in a part of the pond with less competition.
The MOAT of the company is completely defined by its intangibles :
2 strong IP’s, The Witcher and Cyberpunk. A third unknown IP is in the making
The know-how and experience to develop these complex RPGs
The Witcher 3 Wild Hunt, a game they released in 2015 won the game of the year award and was received with critical acclaim. A great example of the popularity of the Witcher IP: When Netflix released their tv series based on the Witcher 5 years after the game’s release, CD Projekt saw a surge in sales for this game. In addition, the COVID crisis had a positive impact on the number of downloaded games. It even became their best sales year in the Witcher franchise. (in the number of items sold, you didn’t pay full price anymore at this time).
Their apply a fly-wheel approach in other media formats in order to increase popularity of the IP and sales of the games.
They have developed the knowledge and skills to develop very intricate triple-A RPG experiences. Very few game studios have these capabilities.
The barrier to entry to develop a video game is low. But the barrier to entry to develop a triple-A RPG is high. Throwing a pile of money at it will not be sufficient. It’s a combination of creativity, technical skills, and a lot of time and money.
I would say that the main competitor for CD Projekt is itself (Cyberpunk launch). They need to replicate what happened with the release of The Witcher 3, where they underpromised and over-delivered.
Is the company profitable?
What are their costs?
Operational expenditures have risen since 2017. Costs now should be considered about 70% of sales with a drop in 2020 during the release of Cyberpunk. These costs will increase further in the future based on the renewed strategy.
General and administrative costs have increased due to the growth of the organization.
The staff has tripled since 2015, and G&A costs have quadrupled. The large increase in 2020 is related to performance benefits.
According to their long-term strategy, CD Projekt will establish a new dev team of about 350 people strong to develop the next Cyberpunk game in parallel to the Witcher franchise.
The G&A costs and general salaries will increase due to the new team that will be assembled. CD Projekt currently has 493 staff. The increase in employee costs will be more than 350/493 because developers in the US have a higher salary than in Poland. We estimate a developer in the US to earn double that of someone in Poland.
How efficient are they?
Return on equity is high when compared to other companies in the industry. The return on capital employed shows a similar profile and value.
On average, CD Projekt achieves an ROE of 30%.
The ROE for Take-Two Interactive
And that for behemoth: Activision Blizzard.
Of course, it may seem unfair to compare these companies due to their differences in size. Because of the 5-year release cycle, CD Projekt the ROE changes a lot year by year. If they can release more games in the future as is the case for Take-Two Interactive, ROE can stabilize. In the short term, ROE will suffer because of costs that need to be made to fuel the future and the absence of big releases in the coming years.
Earnings and free cash flow
When looking at past earnings or free cash flow, and because of the long tail following each release of a new game, it is easier to illustrate the growth of the company between cycles instead of looking at it annually.
The growth between the first cycle and the second one which started with the Witcher 3 is enormous. But this growth is not useful in a further estimate of future outcomes. If we extrapolate earnings and free cash flow based on H1 2022 data, the company is growing at a rate of roughly doubling earnings or free cash flow every 5 years. Doubling every 5 years or quadrupling every 10 years corresponds to a CAGR of 15%.
Earnings have been largely retained in the past. No share buybacks have occurred but this is not unsurprising viewing the high share prices for the last decade. Since 2017, the company started giving dividends to shareholders, but these dividends are not consistent. They are again following the cyclicality of the business. The table below shows the dividend history.
From a capital allocation point of view, it may have been more interesting to use more of the cash to fuel future growth instead of paying a high dividend. I do not expect additional dividends in the following 2 years.
CAPEX is dominated by expenses on development projects. Only a small part goes into acquiring fixed assets which are logical for a game company. These are costs made to develop the video game before the actual phase of selling the game. This can be licensing of a game engine or other tools and services by contractors needed during the development cycle.
Operational cash flow as expected depends heavily on the year of a game’s release. 2015, 2020, and 2021 show this. After the release of the Witcher in 2015, gradually operational cash flow decreases because of the long tail of the release cycle, and CAPEX costs increase to fuel the development of the next game. Free cash flow in this way drops year by year until the release of the next game where the cycle begins anew.
The working capital is different before the release of the Witcher 3 and after.
Before 2015, CD Projekt was a video and board game publisher and distributor with a focus on localization and digital distribution through GOG.COM.
But after 2015 the working capital is the following.
Inventories are no longer displayed as there are few and the number is marginal in comparison. The company has maintained a strong cash balance since then.
From a financing point of view, the company has no debt. It is entirely equity financed. From the equity side, there has been a 5% increase in shares outstanding since 2015. Their pure cash position without short-term bank deposits now sits at 411 million PLN.
The company has thus a conservative manner in managing the company. No debt is engaged and a minimum cash balance is maintained. In 2009, during the financial crisis, the company almost went bankrupt. It had to lay off nearly half of its employees (350) because of huge cash flow problems. The cofounders gave up 22% of their ownership to finance and keep sufficient liquidity.
Management
35% of the company is owned by individual insiders which is good from an investor’s perspective :
Marcin Iwinski, Co-Founder, and current Co-CEO owns 12.7%. He is stepping down as co-CEO at the end of the year
Michal Kicinski, Co-founder, and current Co-CEO owns 10.3%
Piotr Nielubowicz, CFO owns 6.8%
Adam Kicinsi, who was the first employee of the company still holds 4% but left the company since 2013
A short paragraph on Adam Kicinski from an article in forbes
But Kiciński had finally had enough of the warp-speed schedule required to produce a video game worthy of the lucrative Witcher series—he would not stick around to lead the Cyberpunk 2077 build. Within the industry, CD Projekt Red was notorious for burning out its employees in the final months of production, known as the “crunch.” Given the pressure to produce another blockbuster game, Kiciński understood that the only way to meet the unforgiving deadlines was to cut corners and fix the glitches after launch. Such flaws in the production pipeline would eventually become disastrous for Cyberpunk 2077, but Kiciński left that for others to solve. “Once the company got stable,” he says, “I felt confident I could leave.”
The crunch, long work days, and increased pressure to meet deadlines have been broadly reported by the media in the past.
Management stated in their strategy update for the future that they would address the problem going forward. No additional information is available at this time.
One of the questions to ask when hunting for a multi-bagger company: has management made the right decisions with regard to capital allocation?
Although the past 15% CAGR growth and current cash cushion are positive, I wonder if instead of paying a dividend to shareholders, that cash would have been allocated better directly inside the company to fuel its growth and its future ambitions. Share buybacks weren’t really an option in the past.
What is the Value of CD Projekt?
In the past, the Peter Lynch chart looked like this:
When looking at the past, the market has systematically given a high valuation to the company. The PE of 37 used is the median PE for the period observed. Based on the Peter Lynch chart, the best moment to buy the company would have been 2015, when the price of a stock was trading at 23 PLN. This is the only moment in history where market prices were lower than the estimated value based on a PE of 15.
To value the company, tangible book value and net current asset value are of no use here. The main value inside the company is intangible. The knowledge and experience to develop triple-A RPGs, the value of the IPs, etc.
Before going into the art and science that is valuation we need to discuss the company’s ambition based on its latest strategy update.
The strategy update published in October 2022 sees a different company for the future. A summary:
Developing the next game in the Witcher franchise ( a trilogy) to be released in 6 years. In other words, 1 Witcher game every 2 years
Parallel development of 2 triple-A titles. Specifically the next Witcher game and the next cyberpunk game (project Orion)
A new studio will be created in the US. The goal is to hire about 350 people internally)
A third party will develop another Witcher game (we now know it will be the next-gen remake of the original Witcher game)
Development of a new IP (project Hadar) is already ongoing to add more breadth to the company
Transforming from a waterfall to an agile software development method
You could consider 3 levels for CD Projekt as a company :
1. Before 2015: game development and publishing. The majority of revenue was generated by GOG.COM
2. After 2015: The majority of revenue was generated by the sale of their games. 1 game is released every 5 years
3. After 2022: Increase the base of the pyramid. Create a company that delivers more games in a 5-year cycle based on 3 IPs.
In the short term, they are working on the next-gen version of the Witcher 3 (You only need to buy it if you do not already own the game) and the upcoming Cyberpunk 2077 expansion called Phantom Liberty.
To put this on a timeline, this is what CD Projekt would like to accomplish. The data mentioned in the table below are my estimates. There is no official timeline from CD Projekt.
If this is indeed what they are aiming for, then CD Projekt is indeed very ambitious for the future.
What does this mean?
As we discussed when looking at past earnings and free cash flow, their current growth rate is about 15% CAGR. What would it mean to maintain this kind of growth going towards the future? This would mean doubling again between 2025 and 2029.
A ‘simple’ way to achieve this, is to double the number of games released during a single cycle. This is what the management strategy is aiming for.
Assigning a value range to CD Projekt
We use the valuation approach described by Seth Klarman in his book: Margin of Safety.
Valuation should not be considered with precision. Each model is flawed. Everything depends on the parameters used. Bullshit IN equals bullshit OUT. Therefore a range from worst to best will be used and compared to the market to measure if it is probably undervalued or overvalued.
Valuation will be done by using a typical discounted cash flow. These are the parameters taken into account in the model :
Discount rate: US 20 Year treasury rate + equity risk premium = 4.5% + 8% = 12.5% -> We’ll take a 15% discount rate.
Terminal multiple: 15
Consider the following two cases:
A bear case where the company repeats what they did in the past: releasing 1 triple-A game every 5 years = they are unable to execute their new strategy
A bull case where the company executes flawlessly on its strategic update: 1 triple-A game released every year= they execute perfectly on their strategy
The Bear
The bear case means we will copy past free cash flows from the past and these will provide an estimate for the next 10 years. This means that :
· They are unable to assemble a new team in the US
· The 2 games that will be released have the same performance as Cyberpunk 2077
· Since CAPEX costs have been steady for the last 5 years, these are maintained
· They will keep their cash pile steady in a conservative manner
· Free cash flows between release years will show the long-tail effect
· This is the no-growth scenario as the next 5 years will give similar results as the last 5 years
Because there is a high fluctuation in the stability of the free cash flows, the final free cash flow used to calculate the terminal value will be the average of all previous free cash flows.
The Bull
In the best-case scenario, we are going to assume, the release of 1 game every year as of 2026 with a free cash flow generated equally to what was made during the release of Cyberpunk 2077. No free cash flow is generated from 2023 to 2025 due to increased OPEX and CAPEX costs.
But because we want to be conservative, a margin of safety of 30% will be applied to the final result.
For comparison purposes, a second bull case but with a lower discount rate (10%) and a higher terminal value is used (20).
And here are the final results represented in share price (PLN).
Based on this value range, we consider that the market is overvaluing the company.
In both cases, the transformation from a waterfall development method to an agile method will be difficult. I do not consider these possible efficiency gains in the valuation.
In September 2022, the price dropped to 78 PLN. Several positive news items propelled the stock upwards :
The positive reviews of the anime Edgerunners series
Increased players on Steam of Cyberpunk
The newly updated strategy for the long term
But investors need to take into account that :
Besides the news, nothing has changed from the business side of things
The updated strategy will in the short term probably decrease company earnings due to the hiring of new US staff and more CAPEX spending to develop 2 triple-A games in parallel
In other words, Mr. Market is not doing us any favors at the moment.
The second bull case allows us to visualize that to justify the current market price. CD Projekt will need to release a Cyberpunk financial success every year, starting in 2026.
In other words, although I like the company and the product it delivers, current valuations are far too high to justify buying this company. The base scenario is probably not realistic but shows a conservative approach to valuation.
What is the market consensus about the company?
With an average target price of 103 PLN from these 19 analysts.
Conclusion
CD Projekt started as a publishing and localization company for games in Poland. They transformed themselves into a game development/publishing/distribution company and achieved great success with the Witcher franchise. In a 5-year cycle, the Witcher 3 and Cyberpunk 2077 were released with great success. The company now wants to shift to the next level which is producing triple-A games at a faster pace and adding a new IP into the mix to create a broader foundation of its product pyramid.
CD Projekt SA is a great company. It is financially sound, has a great cash cushion, no debt, creates free cash flows upon the release of its games, and has a high return on equity. The business is highly cyclical though which complicates the valuation a bit. Upon release of their games, it creates a high return on investment. Excess cash is used to fuel future development and since 2017, a part of the cash is used to pay dividends to shareholders. There is sufficient skin in the game, 35% is owned by individual insiders.
The value assigned by the market is too high at the moment. When buying, expect some volatility because the news impacts the stock price. If the price would get to 50 or 60 PLN, and business fundamentals have not drastically changed, I believe downside risk should be limited. The bankruptcy of the company is very unlikely given its financial health. Based on past data, it is not the most predictable company for the future. CD Projekt is listed on several stock exchanges (Poland, the US, and Germany), being the most liquid in Poland.
To conclude, this CORPO-rat thinks that multiplying your eddies won’t be easy in the long term, unless the entry price in the market decreases.