Updated: Jul 2, 2021
Frontier Developments is a British video game developer and publisher established in 1994 by David Braben, which develops games across multiple platforms using its cross-platform technology, Cobra. Frontier publishes its own game titles using this technology, alongside working for third-party publishers such as Microsoft, Amazon, Konami and Atari. Frontier Developments had its IPO in 2013 and is listed on the AIM market. This article will examine whether Frontier is a good long-term investment opportunity.
Elite Dangerous, the new release of Frontier's longest-standing game
Frontier's founder David Braben began his work in the games industry in 1982 when he co-authored the seminal game Elite. Elite’s open-ended game model and revolutionary 3D graphics led to it being ported to almost every home computer, and thus it earned its place as a classic. Elite is one of the longest-running video game franchises.
Frontier has performed a shift in business strategy since its creation in 1994. It began as a small developer, which designed and built games for large publishers. Now, Frontier has managed to transform itself into a vertically integrated development and publishing house, which controls the lifecycle of its games from thought conception to build to point of sale.
Frontier has been a market darling since its IPO in 2013. However, its shares are off 30% due to a general cool-off of listed gaming companies and a recent lukewarm update.
This trading update, released on the 11th of June, detailed some of Frontier's current games in development, its revenue for the full year 2021 and importantly the outlook for revenues in 2022. Frontier announced revenues for 2021 would be £91m, just shy of the £93m guided, and the outlook for 2022 would see revenues between £130-150m, a slight softening of guidance from prior expectations. 2023 revenues are expected to be between £160-180m.
Frontier also updated us with the scheduled release of Jurassic World 2, the sequel to their best selling game to date, Jurassic World, which will be released in the calendar year 2021, (financial year 2022).
So, the market was a little underwhelmed with the most recent update from Frontier, and adding this to the general cool-off in British video game stocks of late, Frontier is currently trading at a near 30% discount to its peak valuation back in April.
Frontier is anticipating strong revenue growth over the next few years. Its own estimates show growth of 54% and 21% for the midpoint of expectations in 2022, which by any investors standard is pretty punchy. So how is Frontier going to deliver this, and what titles will be key to unlocking this growth?
Firstly, one of the key attributes to Frontier’s business model is that it is an integrated games developer and publisher, which means Frontier both creates its own games and is responsible for the ownership and sale of titles too. This is not always the common method for smaller gaming companies, but it certainly increases the level of quality to the company's earnings stream. By having ownership of core titles such as Jurassic World or Elite Dangerous, Frontier benefits from post-release revenues as the games mature over time, allowing for more predictable cash flows than a contract based development model. The above graphic showcases how games such as Jurassic World Evolution and Planet Coaster have contributed to cumulative cash flows over time. Frontier expects to support its releases for a minimum of 4 years, allowing for a decent return and compounding growth profile as Frontier increases the size of its catalogue. Therefore, there should be no surprises that much of the revenue growth in 2022 & 2023 will be derived from existing titles. However, Frontier does have several releases up its sleeve.
Jurassic World 2 is expected to be the key release in 2022. The game is owned by Frontier and a license fee is paid to the owners of the Jurassic Park franchise (Universal Group) for the use of IP. The first edition of the series was Frontier’s biggest revenue contributor to date, with 4 million units sold and a review of 9/10 on the Steam gaming platform. The dinosaur simulation game was a huge success for Frontier, and I’d expect the sequel to be hotly anticipated by fans of the prior version.
In 2023 they have another licenced game, this time licensed from fellow AIM company Games Workshop — a strategy game based around the Warhammer: Age of Sigmar fiction worlds. The Warhammer franchise from Games Workshop has been incredibly popular, with massive success seen in similar games such as Total War: Warhammer II, which topped player charts and accumulated a total of 16 million hours played on Steam to date. The signing of a Warhammer game also points to confidence in Frontier’s content quality, as Games Workshop is typically very picky with who they choose to partner with for licensed content.
Besides releasing new games to boost growth over the coming years, Frontier has also carved out a totally new business unit, which it expects to be a significant driver of revenues and profits in the long term. Frontier Foundry is the name of this unit, which will specialise in publishing third party studio’s games. Frontier started out as a development studio, and now it will be sourcing games from other studios to add to its own published catalogue. I personally think this is a great move for the business, as it utilizes the existing framework Frontier already has in publishing its own games, whilst significantly reducing the risk of content creation. This means that less investment will be required to develop these games, and the business unit should support top-line growth, but not significantly increase Frontier’s cost base.
Is Frontier a Quality Business?
There are a few key points to look out for when determining the quality of a business, but the main things I like to look out for are:
A company that can sustainably grow revenues
A competitive moat
A strong management team
The first two statements can be pretty simply answered, and in the case of Frontier, I think it passes both criteria. With revenue growing 20% in 2021 and expectations for 54% and 21% growth in 2022 and 2023 respectively, I think it is fair to suggest Frontier is a growth company. On the sustainability front, a particular reason I like the video gaming sector, in general, is the endless opportunity for growth, seeing as there is no constraint to growth other than the amount of content a gaming company can develop.
Looking at profitability, Frontier packs a punch here too. Gross margins have typically held steady in the 70% range, and since 2018, Frontier has been delivering operating margins of above 20% with a long term target of 22% for the business. Operating margins are also even better in real terms as Frontier benefits from Video Games Tax Relief in the UK, but Frontier reports operating profit before this exemption to show the business performance before the helping hand from HMRC.
An important factor in the quality analysis of Frontier would be the economic moat that the business has. Whilst all Frontier’s content is protected by intellectual property rights, there is nothing Frontier can do to stop competitors from producing similar games in Frontier’s respective niches. In fact, this is actually a strategy Frontier used to create the successful game Planet Coaster, the now most popular theme park management game. Frontier used to develop RollerCoaster Tycoon for Atari when Frontier was still a contract development business. Frontier then used this knowledge to develop a better version as a competitor. An excerpt from the annual report is below:
“Frontier developed RollerCoaster Tycoon 3 for Atari in 2004 when we were a work-for-hire business and it was a very successful game for over a decade. The success of RollerCoaster Tycoon 3 over such a long period of time meant there was no meaningful Coaster Park competition within the sector for all that time. We knew we could do a better job, and many of the same team that made it back in 2002–2004 were still at Frontier, hence our confidence we could ‘knock it out of the park’ with a new game.”
Thus, when considering a moat, Frontier and any games developer really relies on its people to remain a step ahead of the competition and at the cutting edge of ensuring the pipeline is full of content that gamers are willing to engage with and purchase. Frontier seem well aware of this, citing the 2020 annual report, risk #1 is talent acquisition and risk #2 is talent retention.
Looking at the results for employee satisfaction at the Glassdoor review website, Frontier receives a pretty solid rating of 3.8* — about average for small games developers in the UK. Looking through these reviews, people seem generally happy with the culture, although as they are based in Cambridge, it seems people are requesting higher salaries! Seeing as talent is so critical to a creative business like this, investors should keep a keen eye on staff retention to ensure Frontier has the creative capacity as it moves from a smaller ‘indie’ business to a more commercially focused publisher.
Lastly, a key quality component that I think Frontier excels in is its management team. The business is founder-led, with David Braben still as CEO and holding 32% of the stock, you would expect the business to be highly aligned with shareholders. Frontier’s management has instilled a highly successful strategy, which the company has managed to stick to in building quality content and expanding this content with add-on packages as opposed to ‘play-to-win’ features that can reduce playability or engagement. Management has also been able to create a high growth business without taking on considerable amounts of debt or raising capital through equity placings (to my knowledge the last equity placing was in 2017). This astute capital management is likely due to the cornerstone holding from David Braben preventing anything destructive happening to the business.
Just to highlight some of the key risks to the investment case, I believe the main risks remain to be:
Asset execution — Frontier's results are reliant on the successful release of a core number of titles. Delays have been seen for Frontier, as they pushed back one title to 2022. Covid-19 has caused other developers such as CD Projekt Red and Ubisoft to do the same, delaying releases to ensure they put out quality content due to the struggle of the current working situation. This is mitigated in Frontier’s case as 60% of revenues are typically derived from existing content in the catalogue.
Talent retention — As previously alluded to, Frontier's success is derived from its talented development staff. As seen in the creation of Planet Coaster, having held on to staff from 2004 who developed the Atari Rollercoaster Tycoon game, the retention here played massively into Frontier’s strengths in moving quickly with a better quality re-build.
Acquisitions — The gaming industry is fastly consolidating. Often developers will opt to buy small gaming businesses to recruit talented staff in large quantities. Multiples for small gaming companies have risen significantly since the EA acquisition for Codemasters in 2020. It is a risk to shareholders that Frontier may engage in pricey transactions. Again, this is likely mitigated by David Braben's large shareholding.
Looking at the financials for Frontier, revenue has grown in a step-based fashion, with large increases on the release of major titles, which then seem to consolidate before moving higher. Whilst this does cause some ‘lumpiness' to Frontier’s revenue cycle, this will likely even out as its catalogue of games grows in size, and despite this nature, on a long term view, growth has been impressive.
Gross margins have declined slightly over the years, but have made a recovery in 2020. Despite this, operating margins have been pretty solid over the last four years and I would expect more stability here as the business grows scale. Frontier’s return on capital figures are a little underwhelming, however, I would expect this figure to improve again as the catalogue grows in size and the fixed cost base becomes spread across a larger amount of revenues.
Lastly, looking at the balance sheet, Frontier is incredibly strong. It is in a net cash position of £34m and currently has enough cash and receivables to pay off all its liabilities.
I think Frontier Developments represents an interesting opportunity for investors here. The business has a good track record for long term growth, it owns a decent catalogue of titles that produce increasing cash flows and the founder-led orientation of the business has allowed for strong implementation of strategy and astute capital management of the business.
Weaker than expected guidance has knocked the shares, which now sit on 34x 2022 earnings estimates. Any further weakening of guidance will likely lead to a fairly significant de-rating, but I would suggest consolidation in the industry puts a floor under Frontier’s shares. If Frontier can stick to its guidance of £130-150m in 2022 and continue to deliver strong updates to the development pipeline, I think Frontier can rebound and investors with a long-term horizon will be rewarded.
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At the time of writing, The Twenties Trader did not own shares in Frontier Developments.
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