Description

Remedy Entertainment (REMEDY FH)

1.     Executive Summary

Remedy is a relatively small, founder-led, premium video games developer listed in Finland (IPO in 2017). Founded in 1995, it came to fame in 2001 with the Max Payne titles which received critical acclaim due to the focus on story, atmosphere and visuals - attributes which have remained key to Remedy games. Currently it employs ~280 people (vs ~130 in 2016), designing and producing PC/console games. Remedy has been profitable for a decade, with 10x more revenue now vs. 10 years ago, setting up a resilient track record of game development. Des­pite a >20% CAGR growth rate since 2015, Remedy remains relatively unknown within the investor community due to thin coverage and low market cap (~€500m). In 2020 the company signed a novel partnership deal with Epic Games to co-develop a series of games, presenting optionality for the stock which we believe to be mispriced by the market. The partnership substantially improves the game development economics and distribution opportunities. Our conservative view suggests 50-60% upside, with the potential for Remedy to gain multibagger status.

2.     Business model

The PC/console video games market broadly breaks down into three areas: game developer -> publisher -> distributor/retailer. Some play across multiple parts of the chain simultaneously (Epic Games, Activision Blizzard) whilst others are focused (Remedy - a game developer, Steam - an online PC game distribution platform): 

• Developers are typically the creative force behind games, often responsible for concept creation, building, narrating and producing a final product, whilst working closely with publishers

• Publishers can also have a significant say in the nature of a game as they often provide a large portion of the funding upfront, marketing, distribution and project management support. Some developers choose to self-publish games, whilst some large publishers have developers working for them. When working with smaller game developers publishers own a larger portion of the upside through greater revenue share and retaining the IP rights

• Online distributors (e.g. Steam, Epic Games) provide a marketplace/online store where gamers ultimately purchase games with the distributor taking a fee from the final retail price (~30% for Steam). Marketplaces like Steam often come with social network aspects, where gamers can leverage Steam’s multiplayer capabilities to play together with friends across multiple games, whilst maintaining a social profile and winning achievements. Retail distribution is still present for the PC and Console markets, but is in overall decline

As an independent game developer, Remedy relies on the creation of successful titles. It operates under a mix of agreements: as a development studio for hire (subcontractor) where publishers and larger developers pay Remedy development fees (without Remedy retaining the IP or revenue upside) or as a developer which works with publishers and retains part of the revenue and IP upside. Recently the company has also said it’ll aim to self-publish some of its smaller future titles, selectively taking on greater risk but also retaining more of the upside (Fig 1). As such, when deciding on a commercial model for a game, Remedy must consider the revenue and cost implications of each project type (Fig 2).

Fig 1 - Avenues for revenue generation for a game developer

Source: Remedy CMD

Fig 2 - Revenue and cost implications for Remedy by project type

Prior to 2017, Remedy derived the majority of its revenue from subcontracting work as a studio for hire, receiving development fees from publishers and/or larger developers. A smaller proportion of revenue came from unit sales of games through revenue share. The operating model until 2017 mostly revolved around focusing on a single title, often taking 4+ years to finish a game, with limited upside. The single-project workflow and subcontractor nature of its game development limited Remedy’s growth, before the company changed its strategy in 2016/17. In 2017 Remedy shifted to working on multiple projects at any one time (5 games in parallel during 2020 for 10 gaming platforms) and now is less reliant on subcontracting work. As such, it reduced its risk profile around relying on the success of a single title, diversified its revenue profile, and started to capture more of the upside. 

Despite no major games releases in 2020, revenue grew organically by 30% (Fig 3), driven by unit sales with the related revenue share from its Control title (launched late Aug 2019) and development fees received under the new Epic Games agreement. EBIT doubled in 2020 due to higher revenue and the company starting to capitalise some game development costs in 2019. If these weren’t capitalised EBIT would still be ~62% higher in 2020 vs. 2019. The marginal unit economics are extremely positive for Remedy given the fixed cost nature of its game development. Most incremental revenue from units sold on a digital store drops straight through to EBIT due to limited incremental costs associated. Gamers downloading content on their own hardware means Remedy doesn’t have hosting costs and the single-player focus of Remedy’s games limits the need for increased tech support costs. This contrasts with large online open worlds with multiplayer games which typically require ongoing hosting and support costs as the user base scales.

Over the last decade Remedy has gone through three evolutionary stages of its business model:

• Up to 2016: mostly subcontracting work on a single project

• 2016-2021: increasingly seeking revenue share agreements whilst working on multiple projects

• 2021 onwards - aiming to own the IP of most of it games as with its Epic Games agreement, improve distribution, whilst also considering self-publishing for some of its smaller titles (e.g. Vanguard) under its new 2021-25 strategy

New strategy & goals for 2021-25: During its first ever CMD in 2020, Remedy announced that it aims to create at least one major hit game (a game that reaches global top selling charts) and several “successful” games, whilst launching at least one game and/or expansion every year. It also aims to capture more of the created value going forward, building capabilities to select the right commercial model for each game, including self-financing, self-publishing and working with strong publishing partners. Overall, its long term goal is for profitable growth through an organic expansion of its portfolio by iterating towards bigger games “with professional and scalable game productions”.

In 2021 management expects revenue and operating profit to increase, with the two Crossfire games expected to launch by its publishing partner. The majority of revenue growth is expected to materialize during the second half-year period. 

Game development: In order to develop most of its games, Remedy relies on a proprietary game development engine - Northlight, which leverages its years of experience in visually strong games and storytelling. The development for the games with Epic is said to be leveraging Remedy’s Northlight engine. Additionally, Remedy has started to leverage Epic’s Unreal 4 for the development of its free to play game, Vanguard, and is hiring additional game developers with Unreal 4 experience, suggesting it could leverage Unreal 5 going forward as the start of full production on the larger Epic title coincides with the Unreal 5 engine preview in Spring 2021. The Unreal engine is known to be strong in its ability to support online multiplayer-world games.

Remedy employs ~280 people directly and leverages ~31 external partners (~370 talent for Remedy in 2020), working on 5 games for 10 platforms across 15 separate projects. Around 100 out of 280 people (~40%) are currently working on the Epic projects. Given the multiple-workstream environment, each project is said to refine the next, iterating learnings, assets and employee skills. It has also started to invest in an internal publishing unit given the revamped strategy in 2020.

Metacritic scores for Remedy titles (over 75 = well regarded):

• Control (2019): 82

• Quantum break (2016): 77 

•  Alan Wake (2012): 83

• Max Payne (2001, 2003, 2012[2]): 89/86/87

Management team: Founder-led with CTO and Chairman Markus Mäki controlling 28.6% and Chief Creative Director Sami Järvi at 7.1%. Järvi is a well-recognised figure within the industry on which the Max Payne look was based. The CEO, Tero Virtala, joined in 2016 and led the operating model revamp. He’s an ex-CEO of gaming company RedLynx for 13 years which was acquired by Ubisoft in 2011. After the new CEO joined in 2016 and following the strategy & operating model revamp in 2017, staff turnover has declined from 14.3% to 7.5% in 2019 and 7.1% in 2020 according to Remedy.

Financial performance to date: Over the last decade Remedy has established a resilient track record of profitably developing and launching games. Revenue has grown every year since 2013 (Fig 3), due to iteratively more successful game launches and the move away from the subcontractor, one-game-at-a-time model. The multiple workstreams have also resulted in reduced revenue fluctuation, which was a feature of the old model (e.g. 2010-2013 in Fig 3). The shift in strategy is also reflected in improving average margins from ~9% EBIT in 2010-2014 to ~15%[3] in 2015-2020. As mentioned in the Business Overview section, striking revenue share deals with publishing partners is more profitable due to the improved unit economics vs. a fixed subcontractor rate, especially if the game title is a success. This allows Remedy to capture a higher portion of lifetime value of its titles - we estimate Control to have contributed ~€15-20m in royalty revenue for Remedy in 18 months between Aug 2019 - Dec 2020. Under the Epic agreement, the opportunity to capture even more LTV increases. 

Typically the most profitable years for Remedy have been during game launches (e.g. 2012, 2016). In 2020, despite no major title releases, revenue grew 30% organically YoY driven by higher volume of sales of its Control title (launched in Aug 2019) and new development fees received from Epic, resulting in a doubling of EBIT (or +62% growth if adjusted for change in capitalisation policy in 2019).

More than 60% of costs relate to personnel, which in turn are mostly developer salaries. Costs in 2020 grew by 24% primarily due to increases in headcount (16%) as the company scales to handle multiple game development workstreams, as well as slightly higher average FTE cost (4%) due to higher bonus accrual. The pandemic partially offset costs due to lower travel expenses.

Cash generation is typically volatile for game developers due to timing differences of royalty payments, FCF showed a strong positive swing in 2020 due to such timing differences.

The company is well capitalised with an average cash balance of ~€20m (2017-2020) and no goodwill. The current cash balance is likely ~ €60m following the share issuance in Feb 2021 which raised €41.5m to execute on the 2021-25 strategy. The raise increased the number of shares by 8.3%. Remedy also paid €1.3m of dividends in relation to 2019 performance and proposed €1.8m for 2020 (€0.10 and €0.15 per share respectively).

Fig 3 - Remedy performance 2010-2020

Timeline:

• Aug 2019 - Control released

• Mar 2020 - Epic announces publishing label with Remedy being one of first three developers

• Dec 2020 - Remedy holds its first CMD, announcing a revised strategy to aim for at least one major hit game (a game that reaches global top selling charts) and several “successful” games 

• Feb 2021 - Remedy announces 30% revenue growth despite no major releases in 2020 and sells an additional 1m shares, raising €41.5m gross proceeds to execute on the revamped strategy (vs. typically ~€20m of cash held on their balance sheet and ~€40m of revenue in 2020).

3.     Why does Remedy deserve a look?

In 2020 Remedy announced a publishing partnership with Epic Games, substantially improving the optionality of the stock. Remedy has become one of the first game developers that would be publishing through Epic’s brand new label, under more attractive terms than previous industry standards. The underlying game development economics for Remedy are likely to face a step change, combined with increased distribution opportunities and an enhanced industry profile.

Epic Games has become a key player in the video games industry through its goal to become a go to place for game developers and gamers alike. An investment from Tencent in 2012 resulted in improved online presence, the success of its game Fortnite raised Epic’s profile (350m users in May 20), its Unreal game development engine is a core tool for many game developers and the public battle with Apple/Google regarding App store fees generated significant media attention. Within the last 2 years Epic also made an entry into game publishing by launching its own Epic Games Store (EGS) in Dec 2018 and a publishing label in 2020. The EGS created a direct to consumer channel by leveraging its large player base whilst undercutting other store rivals with a lower take rate (12% vs. 30% for Steam). It also provides developers the ability to use its Unreal game engine at zero upfront cost and very low overall cost - either a 5% revenue share or as part of the standard 12% fee for the EGS. Epic’s ambition is to improve the environment for game developers and content owners by offering them the best terms in order to enhance the Epic ecosystem. Over the years Epic has proven to be a very successful strategist, developing a unique business model within the video games industry. It diversified away from game development and publishing, created a persistent revenue stream through its Unreal engine which also allowed it to gain access to the latest game developer trends, and be more in touch with the industry as a whole.

Fortnite is now seen by many as one of the fastest growing social networks (350m users in ~2 years), where users don’t come to just play, but to socialise, attend virtual concerts, create their own experiences or simply watch. By leveraging this growing social environment, Epic has started to offer game developers attractive alternatives to traditional publishing and distribution, whilst putting many legacy channels under pressure. Following the announcement of Epic’s 12% fee, Steam responded by reducing its own 30% fee to 25% after the first $10m in revenue and 20% after $50m, raising the question of whether other stores will follow suit. For now,  the improved Steam terms do little for the smaller independent developers who are unlikely to exceed the $50m revenue threshold. Even if legacy stores and publishers choose not to engage in a price war, the Epic Games Store itself will look to gain further ground following its strong start. When launching the EGS in late 2019, Epic simply decided to update the Fortnite launcher app into an Epic Games Store app for all of its PC users, immediately placing its store on the desktop of ~60-70m people[4] resulting in 32m monthly active users in 2019 vs. ~90m on Steam. For 2020 Epic claims to have 160m total EGS PC users, 56m monthly active users (vs. ~120m for Steam) and 31.3m daily active players. Combined with the industry leading terms offered by Epic’s publishing arm, the distribution environment and incentives for game developers like Remedy looks set to improve.

Epic must have had many options when selecting which independent game developers to sign through its new publishing arm, selecting only three to start with. Choosing Remedy speaks well for its reputation within the industry. Remedy will be a key partner for Epic Game’s publishing ambitions, with the deal suggesting an improvement to the underlying economics and industry standing of Remedy. The partnership is important for Remedy as ~40% of Remedy’s employees are currently working on the Epic projects. Historically, when a €40 Remedy game was sold, Remedy would likely get to keep ~€10 on average, or 25%. This varied significantly between 13% to 40% depending on deals with publishing partners and sales channels (retail channels being more expensive). The Epic Games deal implies a likely overall net take rate of ~40%. Furthermore, developers often had to give up IP rights when signing publishing deals. Under the terms of the Epic agreement, Remedy will retain the full IP rights, whilst Epic funds all development expenses (paid to Remedy) of two game titles and commits €10m towards marketing. After recouping its development and marketing expenses, Remedy and Epic will split net revenue on a 50/50 basis (net revenue after the 12% store fee, VAT and other fees). Standard industry practice dictates for the net revenue split to be in favour of the publisher vs game developer as is the case for an existing Remedy title (Control) where net revenue is split 45/55 in favour of the publisher.

On top of the improved net revenue split, publishing through the Epic Games Store and Epic label is likely to incur less overall fees given the 12% take rate vs. the typical 30% for Steam and other channels. Thus, a hypothetical ~€40 game could yield ~€16 of revenue per unit for Remedy vs ~€10 previously, potentially increasing overall revenue to Remedy for a game title by 50-60% (Fig 4).

Illustrative fee breakdown for a previous Remedy title (Control)

Source: Remedy CMD

Fig 4

Source: Company releases and own estimates

In addition to the improved unit economics and Remedy retaining the upside (IP rights), the distribution opportunities of the EGS look substantial. As Remedy is one of the first three developers to sign under the Epic Publishing label, it is likely to feature heavily on the EGS and its ~160m total users (potentially higher by the time the game ship). The publishing deal could include an exclusive window for the EGS.

Overall, the partnership is likely to enhance Remedy’s profile within the video games industry. Being the first of three developers to publish under the Epic Games label is likely to generate more media attention and gamer interest. Additionally, Epic is closely followed by the industry due to the highly anticipated Unreal 5 game development engine, to be available for preview in early 2021. The Unreal 5 engine is expected to provide the next generation of game development capabilities with enhanced features and graphics. Remedy is already utilising the Unreal 4 engine for the development of its free to play game, Vanguard, and could adopt the new engine when available - Epic Games Publishing provides a form of collaborative R&D between Epic’s engine developers and the third party game developers who are likely to have increased visibility over upcoming Unreal capabilities. 

On another note, Epic leaving the IP upside optionality with Remedy, combined with the strong design and single player capabilities of its Northlight engine, could make Remedy an interesting asset for Epic. There have been examples of such cases in the past by Microsoft and Sony. The video games industry has experienced consolidation in recent years, with Remedy estimating that the number of independent studios able to produce AAA games reduced from ~50 to ~30. In 2020 Microsoft said it’ll consider buying more game studios in the future after spending $7.5bn to buy ZeniMax Media.

4.     Remedy games portfolio and pipeline

The video games market experienced rapid growth in 2020 (+20% YoY expected to ~$180bn), but the underlying drives were apparent pre-COVID - proliferation of devices, wider acceptance within the adult population, increasing social element, digital sales, subscription and free to play models. Remedy focuses on the Console and PC markets (~50% of total market), with the trends positively impacting its game development. Its titles are selling for longer (e.g. Control having its strongest month 15 months after launch), it becomes easier to self-publish/finance with digital stores, and game development tools allow Remedy to adapt to changing customer preferences (e.g. developing a free-to-play game using the Epic Games Unreal engine).

Remedy is currently working on 5 games: 2 undisclosed titles with Epic (~40% of staff), subcontracting for Crossfire (a top grossing PC shooter), Control (an adventure game) and Vanguard - free to play, multiplayer, service-based game. The publishers for Crossfire (Tencent and Microsoft) are expected to launch two revamped titles in 2021 (PC and Xbox), for which Remedy developed single player operations. Remedy receives co-development fees from the core developer (Smilegate) and potential royalties. Crossfire is a very popular franchise, specifically in Asia, ranking #2 by Oct 2020 earnings Worldwide for PC, with ~8m simultaneous players. 

Control was developed with a budget of ~€30m and launched in Aug 2019. It received strong reviews, selling 2m copies within 18 months and making a significant impact on revenue in 2020. Sales are said to continue well into 2021, with 2 new expansions launched in 2020 and next-gen console versions released in early 2021. However, some Remedy staff have started to shift focus towards new titles.

The Epic titles take up the largest chunk of staff from Remedy (~100 people) and we think these are likely to have a larger budget than Control (~€30m). One of the titles will be smaller but both will be set in the same universe. The smaller title is already in full production, the larger one is pre-production and will enter full production in early 2021. Estimates suggest Remedy could launch the larger title by Christmas 2022 as Control took ~2 years from pre-production to launch. As the Epic titles are based in the same universe, development could potentially happen faster.

Vanguard is currently in development as a new type of title for Remedy, given its historical focus on single-player games. Vanguard will be a long-lasting, free to play, multiplayer world with over 20 out of 280 people currently working on it. The project is self-financed for now, with the publishing model yet undecided but is likely to derive revenue from subscription services and/or in game merchandise, implying a smoother revenue profile (Fig 5).

Estimated impact on Remedy revenue by title:

• 2021: Control, Crossfire dev fees and launch, Epic dev fees

• 2022: Vanguard, Epic launches and dev fees

• 2023: Epic launches, Vanguard, other (e.g. expansions)

Fig 5

5.     Valuation

Remedy appears to be priced broadly in line with the industry based on current comps and near term expectations from only two sell-side brokers (Fig 6). However, we believe the market isn’t pricing in the newly acquired optionality of the Epic deal, with its positive impact on distribution and the underlying unit economics of Remedy. In 2020 Remedy managed to sell 2m of copies of Control within 15 months of launch under less attractive economic terms, with previously discussed estimates suggesting ~50-60% more revenue under the Epic Games terms. Our estimates suggest that a successful title under the Epic agreement (>7m copies sold) can generate ~€60m in revenue p.a., ~€40m+ of EBITDA and ~€28m in incremental net income for Remedy, more than the current consensus for total revenue and EBITDA in 2023. Margins are assumed to be higher on this title as Epic funds the development costs. At current market multiples of ~18x EBITDA this implies ~€600-700m in incremental EV, higher than Remedy’s current value. In an upside case, a very successful title with 14m copies sold (vs. 20m for Grant Theft Auto V in 2020) would mean an incremental ~€200m in revenue, ~€120m in EBITDA and ~€2bn in EV. 

We’ve assumed that the larger Epic title becomes a relative success with >7m copies over 2 years due to the positive distribution dynamics (vs. ~2.5m for its Control title, 13m for CD Projekt’s Cyberpunk in 10 days in Dec 2020, 20m for GTA V in 2020). Launching in late 2022 at €30.00 per game (~€12-€15 for Remedy) and Epic recovering ~€40m for development and marketing (larger than the budget €30m budget for Control) implying the stated ~€60m and ~€40m in revenue and EBITDA for Remedy in 2023. The LTV of such a title is likely to be higher, at ~€100m (incremental EBIT over 4-5 years), especially since Remedy retains the IP rights. Assuming a low case for the Epic title with 2m copies sold results in ~€20m and ~€13m in incremental revenue and EBITDA. When combined with Remedy’s other titles and the potential steady stream of revenue from Vanguard, consensus estimates of ~€60m in revenue in 2023 seem more than achievable. We’ve assumed Remedy achieves ~€100m+ revenue, ~€45m-€50m in EBITDA in 2023. Applying an 18-20x EBITDA multiple, results in a share price of ~€70-80, which discounted back is ~€60-65 or 50%-60% upside. Additionally, we believe other Remedy titles such as Vanguard will also increase the average life of a Remedy game and by 2025 the company could be in a multi-bagger status with ~€70m in EBITDA and €1.3bn in EV.

We believe the core Remedy business is fairly valued as a resilient model with an established track record. However, the Epic partnership, combined with the revamped strategy for 2021-25 presents significant optionality that is currently under appreciated by the market, in part due to the relatively low sell side coverage and small market cap.

Fig 6 - Valuation comps

6.     Pre-mortem / Risks

• Game development with Epic not going down well with fans (as per CD Projekt’s Cyberpunk)

• Potential lack of big game launches in 2021

• Lower gamer engagement with lockdowns being lifted

• Market rotation away from video games and highly valued tech stocks with return to normality impacting valuation multiples

• New capabilities required to develop free to play games (Vanguard) resulting in delays or lower uptake of the game

Catalyst

• More detail on games developed with Epic (game features, timelines)

• Other releases in the pipeline (e.g. Crossfire to be launched in 2021, Control expansions, Vanguard updates)

• Earnings & Trading updates - 12 May 21, 13 Aug 21

• New sell side broker initiations - Thinly covered so far (Inderes, Redeye, SEB)

• Investor game industry conferences - e.g. Morgan Stanley on 28th May 2021

• M&A - potential acquisition by Epic if games are a success or exclusivity agreements (e.g. Remedy games only on Epic Store)

[1] Assuming game title is successful

[2] Max Payne 3 (2012) was developed by Rockstar Games as Remedy sold the IP rights to Take-Two in 2004. Remedy provided input into the development of Max Payne 3

[3] Weighted average EBIT margin, adjusted for change in capitalisation policy in 2019

[4] Around ~17-20% of the 350m Fortnite players are estimated to be PC users