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2020's Biggest Game, Starring Keanu Reeves & A Little Known Polish Company


Yes, that is Keanu Reeves, who lends his voice and appearance to one of Cyberpunk 2077's central characters.


Introduction


As tech giants battle for ground in a rapidly growing gaming industry it is content that reigns king. This was driven home by Microsoft’s recent $7.5 billion USD acquisition of ZeniMax Media, owner of Bethesda Softworks. This deal nearly doubled the number of studios under Microsoft’s control, and we believe that the little-known indie game developer at the centre of this article has immense potential at a similar valuation. That game developer is Polish based CD Projekt, maker of 2015’s game of the year, The Witcher 3. CD Projekt are set to launch Cyberpunk 2077, the first instalment of their much anticipated second franchise, this November.


Cyberpunk 2077 is a single player role-playing game (RPG) and is described as an “open-world, action-adventure story set in Night City, a megalopolis obsessed with power, glamour and body modification. You play as V, a mercenary outlaw going after a one-of-a-kind implant that is the key to immortality. You can customize your character’s cyberware, skillset and playstyle, and explore a vast city where the choices you make shape the story and the world around you.


The single player RPG will be released in mid-November, followed by free downloadable content (known as “DLCs”) and paid expansion packs in 2021.



Thesis


The market is of the understanding that CD Projekt have been developing the first instalment of their second franchise, Cyberpunk 2077, for the last 7 years. The company’s only franchise to date has been The Witcher, which saw its initial main release in 2015.


Historically, CD Projekt’s earnings have been incredibly lumpy, having been entirely dependent on the release of new Witcher titles and expansion packs. The market’s view is that a second franchise will allow CD Projekt to earn revenue in a less lumpy nature, though still lumpy to some extent, through the release of Cyberpunk titles in between the release of titles from The Witcher franchise.


This view has merit, but it underestimates the scale and scope of the Cyberpunk franchise. A contrarian belief to the market is that CD Project have spent 7 years not on the development of one Cyberpunk game, Cyberpunk 2077, but on laying the foundation for an expansive new gaming franchise that will keep players engaged and spending within the Cyberpunk universe much more regularly (i.e. at least twice per year).


This is in contrast to how revenue has been earned through CD Projekt’s only past franchise The Witcher. This contrarian view has been formed from the facts surrounding the games release, where the single player open-world/role-playing/first-person shooter will release on 19/10/2020. The release will be followed by free DLC’s and paid expansions in 2021. Most importantly Cyberpunk Multiplayer will be released in 2022 and will be sold as a stand-alone title containing microtransactions.


CD Projekt have been executing on this strategy impeccably to date, with the hype surrounding the release of Cyberpunk 2077 reaching heights not seen in gaming since the release of GTA 5. This hype is easily measured through social media engagement, but more importantly through the sales performance of limited edition Cyberpunk 2077 gaming chairs, graphics cards and a limited edition Xbox One X console, which was announced after the Xbox Series X was announced for holiday 2020. The subsequent resale of these consoles online, at what are inflated prices of over $1000 AUD for a superseded generation Xbox that retailed for $549 AUD originally, is a hard data point for the level of hype surrounding the games release. Similar price hikes are also being asked for both the graphics cards and gaming chairs on eBay.


Given that current earnings for CD Projekt are derived solely from The Witcher franchise and their online game retail platform, GOG.com, it would be reasonable to expect the income from both of these existing segments to increase following the launch of Cyberpunk 2077. This increase in income will be generated as more gamers discover the developer and wish to experience their other titles. As for the new Cyberpunk franchise and its pending releases of Cyberpunk 2077, Cyberpunk Multiplayer, and their relevant follow up content, it is lining up to be the most significant launch of a gaming franchise since the launch of Fortnite in 2017.


If Cyberpunk 2077 were to be half as successful as GTA 5, which has sold 130 million units to date and had significant (and similar) tail winds at launch, it would appear to be currently underappreciated by the market. This apparent underappreciation is before considering how CD Project have positioned the release of Cyberpunk Multiplayer as a separate standalone title leveraging any success of its single player predecessor Cyberpunk 2077.



Current Tailwinds


The gaming industry is currently seeing what already was incredible growth accelerated by the restrictions put on mobility and socialising by governments globally in their effort to combat the Covid-19 pandemic. In conjunction with this, 2020 will also see the launch of the 9th generation of gaming consoles, with the release of the Xbox Series X, Xbox Series S and PlayStation 5 in November.


The increasing popularity of gaming as an entertainment form is, however, a longer-term trend, with runway greater than the two aforementioned growth drivers that are confined to 2020-2021. We are currently seeing every major tech company introducing new offerings, whilst also improving their existing offerings, in an effort to gain a share of the gaming market.


Google’s launch of Stadia, Facebook’s launch of Facebook Gaming, Amazon’s purchase of Twitch and recently launched Luna game streaming service, and the aggressive marketing of Apple Arcade are all examples. All whilst Microsoft’s efforts have also increased in intensity over the last two years with the introduction of both Game Pass and Xbox game streaming.


Whilst the industry is seeing systematic and structural growth, it is also true that the attraction of capital to the industry will increase both competition and drive down profitability for a large number of firms. Hence, to produce above average returns it is important to find where the pinch point within the industry is and what companies are poised to continue generating significant income and cash flows whilst the industry grows. To do this a company must have an offering that is inimitable, allowing it pricing power and protection from new entrants who are funded by the capital attracted to the industry.


Intellectual property is of significant value within the gaming industry, primarily in the form of rights to publish franchises and royalties earned from game engines. Rights to publish games from internally developed franchises are an inimitable offering, with an independent publisher and developer having full control of all titles related to the franchises it produces. It is within this category of independent publisher and developer that CD Projekt falls.


Evidence that the rights to franchises and content will be a pinch point as the gaming industry continues to grow is being driven home by recent acquisitions and gaming services offered by large incumbents. One of the most recent and notable events is the acquisition of ZeniMax Media, parent company of Bethesda Softworks, for $7.5 billion USD by Microsoft.


Bethesda independently developed and published leading games of the early 2010s, with The Elder Scrolls and Fallout franchises, and have most recently been known for their role in the reboot of the DOOM franchise.


Control of these franchises and content are of critical value for Microsoft in attracting gamers to its Xbox Games Pass offering, and it would be reasonable to believe that the continued aggressive pursuit of exclusive franchises and content by major gaming platform operators, such as Sony, Microsoft, Google and soon Amazon, will continue to benefit the owners of these inimitable assets.



No Cannibalisation


Revenues earned from the Cyberpunk franchise will not cannibalise revenue from The Witcher franchise that is currently being earned. Conversely it should create a resurgence in sales. The reason for this is the fact that the much hyped and anticipated release of Cyberpunk 2077, and its follow up multiplayer title, will attract attention to CD Projekt and their other titles. With the result being The Witcher titles having greater exposure and seeing an uptick in sales.


Management has hinted at this with the following quote taken from their H1 update: “global recognition and popularity of the Cyberpunk 2077 brand may entice gamers who are not yet familiar with The Witcher games to seek access to the Company’s earlier products.”


This is similar to an author having a runaway success that makes the bestseller’s list and readers seeking out and purchasing their older titles that did not benefit from the same level of exposure at release.


Although this statement is quite coy it is not the main source of evidence that management are also expecting an uptick in the sale of earlier titles. CD Projekt are also in the process of developing a remastered version of The Witcher 3 that will take advantage of the power available in both the PS5 and Xbox Series X consoles.


Given the development strains around the launch of new titles, let alone those the size of Cyberpunk 2077, management would only invest what are limited development resources in the remastering of a 5 year old title if there was reason to believe an attractive return could be earned. With the release of new consoles, a remastered version of The Witcher 3 and the added exposure from the launch of Cyberpunk 2077, it would be reasonable to expect sales of The Witcher franchise to be higher than present over Holiday 2020 and throughout 2021.


The Witcher 3 enhanced for 9th generation consoles

This lack of cannibalisation, and rather the increase in sales for The Witcher franchise, has been missing from the financial press and analyst reports and is likely also being overlooked by the market in general.



Unit Sales Forecast


Prominent comparable releases for Cyberpunk 2077 are Red Dead Redemption 2, Destiny 2, The Witcher 3 and to some extent GTA 5. GTA 5 is the highest selling game of all time with over 130 million copies sold. GTA 5 sold incredibly due to the fact it was released at the end of the 7th generation console cycle, benefiting from both a peak installer base and the fact it repeated sales with existing users when they bought a copy for their 8th generation console.


CD Projekt are providing a free upgrade for individuals who purchase Cyberpunk 2077 for their 8th generation console but who upgrade to the 9th generation, releasing a complete 9th generation version in 2021. Though, CD Projekt will still benefit from launching Cyberpunk 2077 at the end of a console generation cycle as they will benefit from a peak installer base as did GTA 5.


Analyst consensus places sales figures for Cyberpunk 2077 in the range of 15 million to 20 million[1] units within 12 months of its release. Given this, it appears that the market is missing the tail wind the title will experience due to the benefit of a peak installed base of console users.


Ignoring analyst estimates, it is often better to find a suitable comparable title to which we can compare Cyberpunk 2077. This will give us some idea as to how we can expect Cyberpunk 2077 to perform independent of analyst opinion. One such title that has similar characteristics in terms of game design, calendar launch time and similar (yet apparently lower) levels of fan hype is Red Dead Redemption 2 (RDR2).


Below is the sales data for RDR2 as well as The Witcher 3 (W3), CD Projekt’s most recent title release, to give the scale of RDR2’s sales some context.

It is important to note that these figures are calendar year sales figures, with W3 being launched in May, and RDR2 being launched in October, and both sales figures for their launch years being from the launch date until December of that respective year.



Given that Cyberpunk 2077 is launching in mid-November, a month later than RDR2, the sales figures have been revised down to account for this, and to add a level of conservatism, whilst still trying to forecast accurately. Taking this into account sales figures estimates for Cyberpunk 2077 (CYBPNK 77), Cyberpunk Multiplayer (CYBPNK MP) and W3 are below:



Using RDR2 as the most relevant comparable, we believe that Cyberpunk 2077, and its follow up Cyberpunk Multiplayer, will sell better than RDR2, which sold upwards of 25 million units in the first 12 months from its release on a lower console installer base. Though to maintain a conservative approach the data in the above table incorporates a 20% margin of error, and hence uses a forecast of 20 million units shipped in the first 12 months from release.



Net Income Forecast


Forecasting net income is a product of forecasting both unit sales and net income earned per unit sold, and then simply multiplying them to arrive at a net income figure. Given that historical net income figures earned by CD Projekt’s game development business unit, named CD Projekt Red, are readily available, net income earned from each unit sold can be forecasted with considerably more accuracy than sales units.


Based on data sourced from S&P Capital IQ the CD Projekt Red business segment has an average net income margin over the last 5 years of 51%. This data can be found in the below table:



Given that we are able to use historical data on the company to infer that 50% sales will flow to the bottom line for CD Projekt, the parent company, no 20% margin of error has been applied. With more certainty, it is preferable to favour accuracy over conservatism, especially in the case where conservatism is being applied generously to other forecast inputs.


Estimating top-line revenue is also straight forward, and to make the estimates easier to understand the $USD will be used as the base currency. Also, of note is that 60% of revenue is generated from the US market. CD Projekt have announced that Cyberpunk 2077 will retail for $60 on both 8th and 9th generation consoles, as well as PC. This has historically been the price for major titles, though for 9th generation consoles Sony and Take-Two (the publishers of RDR2) have announced increases in pricing to $70 per title.


Another important factor to note is that the industry standard for digital sales is a 30/70 split between the digital store, such as Steam or the PlayStation Store, and the publisher[1]. CD Projekt generates 85% of its revenue through digital channels, with the remaining 15% being through physical distribution where the split between publisher and physical distributor is closer to 50/50. However, considering that CD Projekt captures 100% of revenue through titles sold via GOG.com, and Cyberpunk 2077 has received a third of its PC pre-orders via GOG.com, the differences almost entirely equal out to an aggregate split of 30/70 Between the CD Projekt Red business segment and its distributors.


Taking these inputs, and then again applying a 20% margin for error to the final figure, for conservatisms sake, produces a figure of $16.80 from each unit shipped going to CD Projekt’s bottom line as net income. The data and calculations are broken down below:



Combining the $16.80 estimate with the forecasts for unit sales of CD Projekt Red’s titles produces the below net income estimates from the CD Projekt Red business division:



Forecasting CD Projekt Earnings


Forecasting group earnings is then a process of adding net income from the GOG.com business segment to the net income earned from the CD Projekt Red business segment. A conservative estimate of $3 million USD net income is used for GOG.com, as this is in line with the average income earned from the segment over the past 5 years. This is after adjusting for one-off reorganisation costs that were incurred over the last 2 reporting periods.


Combing these figures produces a total net income that can be found in the below table:




Comparing Forecast Earnings to Current Valuation


Based on the forecasts detailed above it is apparent that CD Projekt is a company that is set to experience dramatic earnings growth over the next few years, even when looked at from a particularly conservative angle. Though this only answers the question of whether CD Projekt is a good company, not a good investment. To work out the later the company’s current price must be considered.


CD Projekt C.A. is currently valued at $10.3 billion USD. When comparing this market cap to conservatively forecasted future earnings, post the release of Cyberpunk 2077, we arrive at a forward P/E ratio of 32 for fiscal year 2020. The comparison of forecast earnings to current market cap from 2020 to 2025 are found in the below table:




Management


The management at CD Projekt are renowned within the industry for being gamer friendly. They are also seen as one of the last publishers of AAA-titles to not rinse their customers with a bevy of microtransactions and undersized expansion packs.


This is because management’s incentives are aligned with the company’s long-term success and not with short-term revenue generation that often comes at the expense of gamer satisfaction. This incentive is driven by the level of management ownership, which is portrayed in the below table:




Concluding Remarks

“The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.” – Peter Lynch

Having to rely on favourable outcomes to produce adequate returns often brings unnecessary exposure to downside risk. This is due to the fact that events often do not play out as planned. In the case of CD Projekt C.A. this appears to be one of those companies, where “things have to go right” for the realisation of an adequate return over the next few years.


This is the first company that I have held within my portfolio, and blogged about, where this is the case. Even though it goes against my gut feeling, it is the numbers and story surrounding the company that makes sense, not my dogmatism.


Taking a step back it is important to recall that the pricing of the company’s common stock appears reasonable based on the growth offered by the launch of only their second franchise. With a heavily invested management team, a growing industry, and a position of power in the gaming industry as the owners of content, CD Projekt find themselves in the right place with an approach that appears to be working.


In conclusion, I believe it isn’t foolish to think that we will continue to see the expansion of CD Projekt’s content library, and more importantly an expansion of the demand for this content over the long term. It is these last two factors that appear to offer significant upside to the long-term investor at the company’s current valuation (9/10/2022).



[1] https://www.ign.com/articles/2019/10/07/report-steams-30-cut-is-actually-the-industry-standard [1] https://www.digitaltrends.com/gaming/analyst-says-Cyberpunk-2077-could-sell-15-million/ https://www.tweaktown.com/news/64222/analyst-Cyberpunk-2077-q4-2019-sell-19m-copies/index.html https://www.bloomberg.com/features/companies-to-watch-2020/

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