Description

I recommend selling short shares of CD Projekt (CDR). The stock’s valuation is simply too expensive for a company whose business model is more akin to a traditional cyclical than many of its video game peers. CDR is likely to face declining earnings over the next 5 years as it attempts to recover the debacle of its most recent release, Cyberpunk 2077.  Shares are already down 60% from their December high, but I believe there to be another 50% downside from here as investors begin to recognize how low probability of a successful recovery really is.  The following is derived from the analysis of company filings and transcripts as well as conversations with industry insiders and experts.

Executive Summary

• Cyberpunk 2077’s failure to gain traction with players should significantly impact CDR’s earnings over the next 5 years. At a time when the company should be rolling outplanned DLC releases and focusing on its next major title, it is instead patching never-ending issues in attempt to reinvigorate interest from a notoriously fickle gaming community that has seemingly moved on.
• Even the most successful games in Cyberpunk’s genre of single player story-driven games have experienced severe declines in units sold in the years following their release. This is a feature of the genre not a bug, yet consensus numbers do not appear to fully reflect the company’s historical earnings trough in between launches.
• Recent video game history is littered with examples of single player story-driven games that failed to translate initial success to online multiplayer, and it is unlikely Cyberpunk will be any different. Furthermore, management has already begun to backtrack on its original plans, putting further doubt on whether it will ever deliver a multiplayer expansion.
• The bull case appears to be focused on hoping that several upcoming catalysts might revive interest in the game. However, there are reasons to be believe that each of these is quite unlikely to have any significant financial impact that will justify CDR’s lofty valuation.
• CDR’s valuation is at a significant premium to its AAA video game peers that possess more recurring revenue and less volatile business models.

Company Overview

CD Projekt is a AAA video game developer headquartered and listed in Poland. With a $4.3bn market cap it is the 14th largest listed company on the Warsaw stock exchange by market cap and the 19th largest pureplay listed video game developer globally. Over the years the company has built a reputation as one of the prominent AAA developers of single player story-driven games. Netflix subscribers will recognize the popular franchise, The Witcher, which has sold over 50 million units across three games since the first launched in 2007. The first two Witcher games were highly rated (81 and 88 on Metacritic) and have combined to sell ~20mn units since the first game was released in 2007. But The Witcher 3 is where the company really built its reputation as the game is generally acknowledged as one of the best released on the last generation consoles (Xbox One, PS4). Since its 2015 launch The Witcher 3 has sold over 30mn units with nearly half of these coming following the release of the Netflix series in late 2019.

Beyond the three main Witcher games, CDR has developed a few different mobile games based on The Witcher. These games have had varying levels of success with volatile results, but conservatively generate ~$25mn per quarter for the company.

It is important to note that while most AAA game studios typically juggle many franchises and multiple releases each year, CDR is a “one game at a time” studio, averaging 4-5 years between releases. With the critical and financial success of The Witcher 3 as well as some aggressive marketing and promises, CDR’s most recent game, Cyberpunk 2077, was one of the most anticipated games of all-time. Much has been written about what went wrong (good summary by The New York Times here) but what matters here is that the launch was one of the biggest flops in video game history. CDR delivered a game so riddled with bugs that Sony actually removed it from the PlayStation Store for six months. Despite the issues, the game still sold well initially with over 13mn copies sold in its first month (many of which were pre-orders), but now copies can be found regularly on Amazon or GameStop at up to 50% discounts. This has thrown a wrench in CDR’s plans to rollout years’ worth of additional content meant to stretch the life of the game. Instead, it has spent the last eight months trying to fix all the bugs before notoriously fickle gamers have entirely moved on.

Investment thesis:

AAA single player games have short life cycles. Beneath the headlines and initial bugs (which will eventually be fixed) Cyberpunk 2077 is not a terrible game. It has an engaging story (starring an animated Keanu Reeves) and is generally a fun single player shooter. It compares favorably to other notable AAA single-player story-driven games like those of Rockstar’s GTA and Red Dead Redemption franchises or ZeniMax’s Fallout and Elder Scrolls franchises. These games are the pinnacle of the single player story-driven genre, and each of the most recent games in each franchise are considered critical and financial successes. The chart below shows how each these games performed in the years following its release (in millions of units). Note that Elder Scrolls and Fallout are excluded from the chart as ZeniMax has not shared unit information consistently since the developer was private until its recent acquisition by Microsoft.

As shown, even the upper echelon of AAA single player story-driven games experienced a dramatic decline in sales volumes in the years following their launch. Many of these games won awards and launched additional DLC (downloadable content) that extended their lives for years. Even so, units sold were down 50%+ in the years following their release. Revenues likely fared even worse as the units sold in Years 2+ are almost always at discounted prices making the dollar-based sales declines even greater than shown above.

This cliff is a characteristic of the single player story-driven genre. These games do not hold much replay value once the player has completed them and it creates a boom-and-bust cycle for the companies that develop them. The pursuit of more predictable revenue streams is a key theme in the industry and has contributed to the rise in popularity of the live-service online multiplayer genre of games have resonated with players in recent years like. This is important to understand because it is the reason why GTA 5 is somewhat of an outlier on the chart above. Shortly after the release of GTA 5, Rockstar introduced a multiplayer expansion to the game called GTA Online that allowed players to play online with their friends in a similar manner to live-service online multiplayer games like Fortnite and PUBG. The addition of GTA Online has helped Rockstar to continue to sell tens of millions of copies of GTA 5 eight years after its release and introduce additional monetization methods such as microtransactions.

Speaking of online multiplayer… Part of the hype around Cyberpunk 2077 was the expectation of a GTA-esque online multiplayer expansion. Management enabled this narrative by frequently mentioning its intention to follow the GTA playbook and launch an online multiplayer mode within the first year or two after the single-player release.  However, due to all the initial issues, management delayed and then backtracked on its original multiplayer plans for multiplayer.

November 2020 (pre-Cyberpunk release) - It’s a separate dedicated production, a big production,” said CD Projekt Red’s CEO regarding Cyberpunk’s multiplayer. “And we plan — we think about it as a standalone product. Obviously, it’s not entirely standalone as it comes from the universe of Cyberpunk and is very much related to the concept of single-player Cyberpunk…. “It’s another independent production and an independent team of people works on it. I said already we are not focusing right now on talking too much about other future products, products that are to be released after Cyberpunk. So please be with us in the first quarter of next year when we plan to share some strategy update. And I believe Cyberpunk multiplayer will be possible.”

March 2021(post-Cyberpunk release) - “Previously, we hinted that our next AAA would be a multiplayer Cyberpunk game, but we have decided to reconsider this plan,” Kiciński said. “Given our new, more systematic and agile approach, instead of primarily focusing on one big online experience or game, we are focusing on bringing online into all of our franchises one day.”

To me this sounds like Cyberpunk 2077 may never receive the multiplayer expansion that was originally envisioned. But even if CDR does manage to eventually deliver a multiplayer expansion, it would by no means be a guaranteed success. With GTA 5 as the exception, no other AAA single player story-driven game has been able to translate its single player success to multiplayer. The list of recent multiplayer failures by AAA studios that are known for quality single player story-driven player is extensive. Over just the last four years we have seen failures from many of the top studios in the genre such as Bioware’s Anthem, ZeniMax’s Fallout 76  and Elder Scrolls Online. Even Rockstar could not replicate its own success with Red Dead Online.

So, what’s the bull case? The bull case hinges on CDR’s ability to revive gamer interest in Cyberpunk following several upcoming catalysts that I believe are unlikely to bring gamers back:

1.     Bulls point to Cyberpunk’s return to the PlayStation Store in June after which it was the bestselling PS4 game of the month. However, this is a misleading data point. For starters, Sony launched its next gen console, the PS5, in November 2020. This implies that most new games are for the PS5 not the PS4. The names below Cyberpunk on the top selling list are a hodgepodge of popular older games that are all available at a discount (GTA 5, Minecraft, Fortnite). We should note that Cyberpunk itself is also discounted on the PS store at $49.99 (from $59.99). But more importantly, Cyberpunk was missing from July’s top sellers list just a month later.

2.     Bulls will also point to this Fall’s release of the next gen PS5 and Xbox Series X versions of Cyberpunk. However, this is a misleading catalyst that is unlikely to have much of a financial impact as players that purchased the game on previous generation consoles can download the next gen version for free. Of course, there may be a small segment of gamers that have held off purchasing the game until the next gen release, but the majority of CDR’s target market has likely already purchased the game.

3.     Similarly, CDR is releasing an updated version of The Witcher 3 for the next gen consoles. But like Cyberpunk, owners of the last gen version can download the new version for free. It’s unlikely this release will drive many incremental purchases of the six-year-old game.

4.     Some bulls still seem to be hanging on the potential for a multiplayer release in 2022 or 2023. I have addressed this unlikelihood above.

5.     A Cyberpunk anime series on Netflix is scheduled for release in 2022. Admittedly, this one has the potential to drive further sales of the game. The Witcher 3 saw a ~60% y/y increase in units sold following the Netflix series of The Witcher, and it could be a potential risk if the show is popular. However, one key difference is that Netflix’s The Witcher is a live action series, while the upcoming Cyberpunk series is an anime cartoon that may only appeal to a smaller audience than The Witcher did.

Valuation & Financials

The table above compares CDR’s valuation (on consensus estimates) with the publicly traded game developers that compete with CDR in the AAA single player story-driven genre of games.  At first glance CDR’s premium isn’t too great compared to TTWO, but TTWO derives a greater percentage of its sales from “recurring” revenue from its annual 2K franchises (mainly NBA2K) and GTA Online, which CDR is lacking. The 2K franchises have a built-in fan base that are highly likely to purchase the new game each year, while GTA Online is a live service game relying on microtransactions from a massive player base. Also notable is that Finnish developer Remedy trades at an even greater premium than CDR. However, the two companies’ outlooks are very different. It’s true that Remedy was once a single project studio like CDR, but that is no longer the case as the developer has undergone a multiyear transition to a multiple project model, which is a major part of the narrative behind the stock’s ~6x run over the last three years. It currently has 4+ projects in development (and a partnership with Tencent) that are expected to drive significant annual revenue and earnings growth for the foreseeable future.

If we assume that Cyberpunk follows the same volume trends as the comparisons in the earlier chart, CDR will sell ~5mn copies annually over the next four years. ASPs can be hard to predict, especially given the discounts the game is already seeing, but let’s assume an average retail price of $40 in 2021 and $30 in 2022-2024 (vs. $49.99 on digital stores and under $30 at retailers like Amazon/GameStop currently). As the developer and publisher CDR captures ~60% of the sales from each unit with the rest divided among the distributor, retailer, and platform. This means $24 per unit in revenue to CDR in 2021 and $18 in 2022-2024. Under these assumptions CDR’s revenue from Cyberpunk would be ~$120mn in 2021 and ~$90mn per year in 2022-2024. Conservatively throw in ~$100mn in annual revenue from the portfolio of mobile games, and we get 2021 revenue of $220mn and 2022-24 annual revenues of $190mn. A 40% net margin (averaged 39% through The Witcher 3 cycle) gets us $88mn in earnings for 2021 and $76mn annually from 2022-2024; implying that CDR is trading at 51x P/E as it enters a downcycle.

Given the cyclical nature of the business, it may also be fair to value the company off an estimate of normalized earnings. If we average the earnings estimates above with the peak Cyberpunk sales of 2020 (shown above) we end up with ~$123mn in normalized earnings (($297+$88+$76+$76+$76)/5); implying that shares are trading at 37x normalized earnings.

I want to emphasize just how conservative these assumptions are. The games we are using as comparisons are award winning games with 90+ scores on Metacritic[1], while Cyberpunk has become a meme with a score of 61. This allowed them to have much longer lives than most games as the developers leveraged the initial success to launch various DLC (downloadable content) and “Game of the Year” editions. Given that Cyberpunk has not been as well-received as these games, it is very possible that volumes (and revenues) will decline at a much greater pace over the next 4 years.

Catalyst