Frontier Developments PLC (LON: FDEV) – Sustainable business model with a sound financial position

Frontier Developments PLC is an FTSE AIM All-Share Index listed software technology Company founded in 1994 and headquartered in Cambridge, the United Kingdom. The Company is engaged in the business of developing video games and non-game applications for the entertainment sector. It uses its cross-platform technology to create games across various platforms. Its segments include external publishers and self-published. Screamride and Tales from Deep Space are some of its key external publishers. In the self-published segment, FDEV offers sales of the game and digital in-game. The Company is consistently on time and on budget across many platforms and has seven years of expertise as a publisher. At present, it has over 600 employees in Cambridge.

In early September 2021, FDEV will announce full-year results ending 31 May 2021.

(Source: Company presentation)

Growth Prospects and Risk Assessment

The video gaming industry has evolved over the years from simple gaming to a multiplayer experience with live streaming and wider interactive features. Video gaming is often considered by many as the vital element of entertainment. During the pandemic, it was witnessed that more people played video games than ever before, and the number of consumers who tried a new digital activity increased significantly. The video gaming sector was highly popular during the Covid-19 situation across the world as people spent the majority of their time at home. The interest of the people supported the gaming industry, and video games are expected to contribute to more than half of the entire UK entertainment sector.

FDEV could leverage this sector tailwind to grow in the short and medium term. All titles continue to perform well, and top-line growth in H2 FY2021 is expected to build on the solid performance achieved in H1 FY2021. For FY2022, there would be new games coming up, including two multi-platform releases as well as some Frontier Foundry titles. Also, the Company expects continued strong performance from the existing portfolio. In a nutshell, the industry prospects are favourable, and the Company has a strong portfolio to tap the underlying market opportunities and gain further market share.

FDEV is undergoing several significant risks, such as credit risk associated with the financial loss of customers and liquidity risk arising from fluctuating interest and exchange rates. There could be market disruptions as it operates in the fast-moving industry with larger competitors. Any new disruptive technology and competitive products could put pressure on the top line and margins. The execution of a business plan could be impacted by the non-availability of a skilled workforce.  Also, due to enormous competition, success is totally dependent on the development of new games. The gaming sector is exposed to regulations and restriction on usage by minors. Also, despite the improving quality of the virtual games, the experience of the real event cannot be matched. 

After understanding growth prospects and risk assessments, we will analyse some key fundamental and shareholders statistics of Frontier Developments PLC.

Financial and Operational Highlights for the six months ended 30 November 2020 (as of 3 February 2021)

(Source: Company result)

• The Company took several strategic initiatives like active player-community management, additional free and chargeable content, price promotions and expansions onto new platforms and channels. These initiatives led to a strong increment in the number of players in all categories.
• FDEV’s own games level for third-party publishing, Frontier Foundry, is ready to become a very important part of business driven by its continuous growth with several exciting titles.
• FDEV has reached a workforce of 600 people as of 31 December 2020 despite challenges by remote working driven by 175 hires during 2020.
• All existing titles achieved solid performance. Also, new platform launches had notable contributions. It led to YoY revenue growth of ~15% in H1 FY2021.
• FDEV adopted efficient cost-cutting measures, which led to lower average distribution costs. It resulted in gross profit margin being up to ~71% and operating profit margin rising to ~19%.
• The Company continued to undertake investments in internal development projects and Frontier Foundry titles. It also did a £10 million share repurchase. Hence, the net cash balance fell to £34.9 million on 30 November 2020 as compared to £45.8 million on 31 May 2020. 

 Financial Ratios (H1 FY2021)

Share Price Performance Analysis

 (Source: Refinitiv, Thomson Reuters)

On 11 May 2021, at 09:20 AM GMT, FDEV stock was trading at GBX 2,770.00, down by 3.15% against the previous day closing price. Stock 52-week High and Low were GBX 3,470.00 and GBX 1,605.80, respectively.

FDEV's price is trading in a bullish trend for more than a year and sustaining above an upward sloping trend line, indicating an upside direction for the stock. On a weekly chart, the momentum indicator RSI (14-period) is trading at ~48 levels, indicating a neutral trend for the stock. Price is trading above the trend-following indicators 50-period SMA, supporting an upside potential in the stock; however, trading below 21-period SMA, acting as an immediate resistance level.

In the last two years, FDEV’s stock price has delivered a positive return of ~159.06%; and it has outperformed the FTSE All-Share Leisure Goods index with a return of around 133.62% and the FTSE AIM All-Share index with a return of about 31.40%.

Valuation Methodology: Price/Earnings Approach (NTM) (Illustrative)

Peers used in the valuation methodology (Price/NTM Earnings)

Business Outlook Scenario

The video gaming sector offers services that could be played at home, and there is no restriction on the time and location. During Covid times, these games are considered highly stress buster, improving mental well-being and the state of mental health. These led to the sector becoming very popular, and it would also drive its future growth. The combination of technology with games has become trending and opened new avenues for the sector. FDEV has all titles continuing to perform well. With new exciting titles on the horizon, it would add to the strength of an already very strong portfolio. In FY2022, FDEV expects two multi-platform releases and several Frontier Foundry titles, combined with a solid performance of the existing portfolio would bring significant top-line growth for the Company. Hence, FDEV could use the strong momentum in the video gaming industry to drive future growth.

(Source: Company presentation)

We have valued the stock using the P/E based relative valuation methodology and arrived at a target price of GBX 3,172.53. On the technical chart, the next important support level is at GBX 2,279.00.

Considering the strong prospects of the industry, solid existing portfolio of FDEV’s business, incoming exciting releases, good profitability and leverage profile of the business, and support from the valuation as done using the above method, we have given a “Speculative Buy” recommendation on Frontier Developments Plc at the current price of GBX 2,770.00 (as on 11 May 2021 at 09:20 AM GMT), with lower-double digit upside potential based on 42.93x Price/NTM Earnings (approx.) on FY22E earnings per share (approx.).

*Depending upon the risk tolerance, investors may consider unwinding their positions in a respective stock once the estimated target price is reached or if the price closes below the support level (indicative stop-loss price).

*All forecasted figures and Peer information have been taken from Refinitiv, Thomson Reuters.

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