CD Projekt, Conviction and Facts

Fundamental errors were made in my recent note on CD Projekt. I want to write about where I went wrong and what, through further digging, I now believe is closer to reality in regard to the Polish gaming company’s growth and recent title Cyberpunk 2077. I can best summarise what I got wrong in one sentence by saying that: I misjudged what the market was thinking, and where it was attributing sources of the company’s future growth.

I didn’t catch myself out on this due to making incorrect assumptions regarding revenue and net income reconciliations to unit sales, and marketability and pricing power of their title Cyberpunk 2077, as well as Cyberpunk Multiplayer. I’ll go into all of these in more detail below and try and shed light on what the market is thinking, the reality of the situation, and why CD Projekt is going into my “too-hard” basket, for now.

Where I Went Wrong

“During a lifetime of buying cars and cameras, you develop a sense of what’s good and what’s bad, what sells and what doesn’t … and the most important part is, you know it before Wall Street knows it.” – Peter Lynch

The important caveat of Mr Lynch’s above quote is outlined by Jason Zweig in his commentary within The Intelligent Investor by Benjamin Graham. Mr Zweig adds that “Lynch’s rule can work only if you follow its corollary as well: ‘Finding the promising company is only the first step. The next step is doing the research’”.

The reason I wanted to highlight this quote is because it is the genesis of my investment mistake in CD Projekt. Just because I knew what was going to be a good title didn’t mean I knew it would be a good investment. Once this error was made the following errors soon followed.

Firstly, the revenue assumptions I made, and extended into the next three years, are flatly wrong on a unit basis. I also failed to consider how heavily discounted The Witcher 3 was 12 months after its release and I believe Cyberpunk 2077 will be too. The reason for this discounting is explained further in the paragraphs on my second error.

My unit basis estimates were wrong as I took a short-cut in calculating the trickle down of net income from revenue under the assumption that distribution commissions are uniform across the gaming industry. This was done rather than relying upon CD Projekt’s individual distribution agreements. I still have not been able to get my hands on any of the details within any of CD Projekt’s distribution agreements to date. Though I still know I am wrong for the following reason.

I am unable to reconcile the company’s revenue when using any of the widely reported standard gaming distribution commissions and the company’s reported unit sales. As I have used the industry distribution commissions in my revenue forecasts this has ultimately led me to conclude that my net income and revenue forecasts for CD Projekt over the next few years are wrong. Given my erroneous forecasting will not reflect the economic reality of CD Projekt’s actual distribution arrangements it is simply useless to use this forecasting in an attempt to determine the company’s value.

Secondly, the game doesn’t have the mass market appeal that will be needed to provide the game with the longevity and continual playability (distinct from replay ability) afforded to other mass market titles, such as Read Dead Redemption and GTA. This underlying mass-market appeal and longevity was a core assumption I based my comparison upon. This judgment is in a large part due to my personal playthrough of The Witcher 3 for roughly 15 hours, which I didn’t do until after my first note was published.

Not doing this prior was a mistake. Playing through a decent portion of a developer’s main titles will be key to any future research I do into gaming companies, rather than reading industry reviews and reviewing video content. Playing video games really can count as research after all.

Upon actually experiencing the genre of game that they produce I understand why they are so well respected within the gaming community, as the level of detail and finesse in their story telling and quest design is nothing but spectacular.

Though, I am of the strong belief that these attributes alone do not lend themselves to attracting the casual gamer. It appears that the casual gamer enjoys titles with shallower skill curves and where intervals between gaming sessions have little to no effect on playability. This is mainly due to the fact that small but important details do not need to be remembered to play.

The continual playability of casual titles without having to restart the game leads to the casual gamer squeezing many more hours out of a casual title over the years whilst they casually enjoy it.

How does this affect pricing? Well, I think that to reach the larger audience CD Projekt must lower the price to continue to attract an audience who see value in the title as a single play through. Where the casual gamer can entertain themselves for a period of roughly 20 hours by doing what core games would call “rushing through” the central story line.

Thirdly, I misjudged buy-side consensus estimates. Through my shallow research I was of the belief that 20-25 million units sold in the first 12 months was the consensus. This assumption was solely my own fault and a direct result of myself simply not digging deep enough. The most valuable piece of feedback I received from the online community was that consensus estimates were actually in-line with my estimates for the game’s first 12-month sales. This was a figure of over 25 million units and close to 30 million units. Hence, I believe that there are limited scenarios where the upside is not correctly priced in. Given this it appears that there isn’t room to make an attractive return given the consensus view seems to be right on the money.

So, Where is the Market Attributing Growth?

The short answer is I really don’t know what the market is expecting of CD Projekt. A likely candidate though is Cyberpunk Multiplayer. I originally thought that this title would draw revenue from an upfront purchase price as well as relying considerably on microtransactions, however, after talking to individuals who follow the company and industry much closer than myself it appears it may be solely microtransactions and a free-to-play model.

With CD Projekt being a laggard in the industry when it comes to moving to a recurring revenue model it would not surprise me if Cyberpunk Online were to rely solely on microtransactions for revenue generation. This could explain the company’s current valuation considering that the investment community looks much more favourably upon companies that have consistent subscription style revenue streams. The free-to-play element would also open a much larger total addressable market for the Cyberpunk Multiplayer title.

The company’s price indicates that there are high expectations around the multiplayer title’s success, along with Cyberpunk 2077. The combination of high expectations, which I do not fully understand, and my inability to gather further details on the company’s plans or distribution arrangements is ultimately what lands CD Projekt in my too-hard basket.

Concluding Remarks

CD Projekt was a stark reminder for me that conviction must be backed with facts. This reminder cost me just over 10% of my position. On reviewing where I went wrong it also drove home the fact that I need to be more aware of my limitations in finding and understanding the facts rather than allowing my thesis to creep based on anecdotal evidence.

Whilst I want to say I will continue to watch the company I probably will not unless there is serious and material downward price movement. This will only be relevant in the event that any price movement offers me an unreasonably large margin of safety in a company in which I am not confident in my own understanding.

Instead, in the meantime, I will be focusing my attention on companies where market conviction is low, and my understanding and knowledge of the facts is relatively high. I currently believe this to be the travel sector.

If I had not reviewed my mistakes in CD Projekt, where I found my conviction to be high and understanding and knowledge of the facts to be low, I doubt I would have had this realisation and corrected the course of my attention. An example I will hold onto of why it is imperative to review mistakes, rather than avoiding the painful process of understanding why you were completely wrong.