Frontier Development(LON:FDEV): Will Operating Margins Recover?

Frontier Development is a small cap UK listed company with a small portfolio of high quality IP that has been steadily growing organically. The company was founded in 1994 by David Braben who remains actively involved and possesses a significant 32% ownership stake in the firm. The company encountered a challenging year in 2022. This difficulty arose from the launch of a new IP, which received positive reception but lacked the brand recognition typically associated with games in their second or third iterations. The soft 2022 killed the stock but at current prices they are quite attractive and as the next ones are released profitability for that game should improve. Furthermore, the company is actively engaged in the development of a new IP, which holds the potential to sustain and further fuel the company’s growth trajectory.

Currency

Given that this company is listed in the UK, it operates primarily in British Pounds. As a US investor, the fluctuating exchange rate between the Pound and the Dollar can significantly impact the return on your investment, either positively or negatively. In assessing the currency risk, I’ve identified two key metrics as crucial, largely influenced by Callum Henderson’s book, Currency Strategy.

Firstly, concerning valuation, the Big Mac index suggests that the Pound is currently overvalued by approximately 4.5% compared to the Dollar. While this represents a slight negative, it’s important to note that this overvaluation is relatively modest, especially when viewed within a historical context.

However, a more concerning aspect is the UK economy’s persistent current account deficit. This deficit has been on an upward trajectory since the late 1980s and shows no signs of turning positive.

Over the past decade, the Pound has experienced a consistent depreciation against the Dollar, declining at a compounded annual growth rate (CAGR) of 2%. Given the Pound’s overvaluation and the ongoing negative current account balance in the UK economy, I anticipate a similar level of depreciation in the Pound against the Dollar in the future, which could potentially offset returns on my investment.

Industry Trends

The video game market is a fast growing sector due to increased participation worldwide. I’ve talked about this before in two articles linked here (link1)(link2). However the current market does seem to be softening. Numerous companies have stated in their quarterly calls that revenue growth has been weak.

Such as 

“Yeah. I mean I love that people are debating whether we’re going to be in a recession from the point of view of a digital entertainment company, we’ve been in a recession for the better part of 18 months. The market for interactive entertainment was down meaningfully in 2022”

– Take-Two Interactive Q1 2024 Earnings Call Transcript

“In the Digital Entertainment segment, net sales and profit declined YoY due to weak performances from existing titles in the Games for Smart Devices/PC Browser sub-segment.”

– FY 2023 Presentation Square Enix

“Current market conditions are making the release of new games into the market
somewhat challenging.”

– Digital Bros 11/07/2023 Trade Update

In fact the video game industry is only projecting 3% growth for 2023 which is quite low compared to prior years. As a contrarian I feel like this creates an opportunity to enter some positions in the sector as I think the long term trajectory is not affected.

The Business

The company was founded in 1994 by David Braben who is still involved with the company. Frontier was mostly involved with space exploration and survival games till they made Roller Coaster Tycoon in 2003 which was probably their highest selling game up till then. After that Frontier mostly made roller coaster type games up until its IPO in 2013. After their IPO the company began to self-publish and began growing rapidly from 10 million in revenue in 2010 to around 114m in 2022. The company’s expansion has primarily derived from organic revenue growth, achieved by developing new intellectual properties (IP) that have evolved from the groundwork laid by their earlier games. The company’s remarkable growth can be attributed to a string of well-received game releases dating back to 2014.

Frontiers Main IP include

Each of these games have been quite well received. And the company seems to have a track record of delivering good games.

Game	Release	Steam Rating	Number of Reviews
Elite Dangerous	2014	Mostly Positive	68,492
Planet Coaster	2016	Very Positive	49,573
Jurassic Park Evolution	2018	Very Positive	45,286
Jurassic Park Evolution 2	2021	Very Positive	17,821
Planet Zoo	2019	Very Positive	59,948
F1 Manager 2022	2022	Mostly Positive	7,329

Source: Steam

Frontier is also not overly dependent on any one game or new games to continually sustain revenue. In the 2023 trading update management said “existing portfolio of games, generating 72% of revenue”. Being able to lean on a back-catalog takes off some of the pressure off of a game developer to continually develop new games titles which may turn out bad. 

In terms of not being too dependent on one game the chart below shows lifetime sales of Frontiers major titles. 

Source: Frontier 2023 H1 Presentation

Jurassic Park Evolution is the company’s highest grossing game but the other major titles are no slouch. Being able to depend on multiple franchises instead of just one gives the business some good diversification in case one franchise sours.

Looking out further, the company “started development of a new internal title for FY25 and are scoping out another new game for FY26”. 

Financials

Like I said above Frontier has grown rapidly going from 10M Rev in 2010 to 114M in 2022. The company recently has hit a little hiccup and FY 2023 revenue is expected to be 104M.

Source: Chart made by author, data from company annual reports

More importantly operating margins have been quite volatile hovering between 1 to 20% margins. This is the nature of the games industry as some games don’t hit sales targets which leads to lower Gross margins and higher R&D costs that depend on the intensity of video game development in any given year, primarily influenced by upcoming game releases. In sum, the average operating margin since 2015 stands at a respectable 15.7%, a commendable figure within the video game sector. 

Source: Chart made by author, data from company annual reports

2022 operating margins were only 1.32% and 2023 operating margins are expected to be low. 2022 was due to the poor performance of F1 Manager 2022. As you can see from the chart below the game was not able to recoup its production costs. The game was the first in the series and had very high production costs since the company had to build everything from scratch. The next ones in the series should have much lower production costs and more than likely flat to more sales which should increase profitability for the future. 2023 margins are expected to be low due to the development costs of the new title to be released in 2024 IE: Age of Sigmar: Warhammer. I think profitability should rebound in the 2024 to 2025 range.

Source: Frontier 2023 H1 Presentation

Because of the volatile OP margins ROIC in turn is also quite volatile. But averaged since 2015 ROIC has been quite respectable at 18%. 

Source: Chart made by author, data from company annual reports

The balance sheet for Frontier is very strong with cash balance at 38M and total liabilities ex operating leases of 27M. This gives the company a net cash balance which is what you want from a video game company due to the volatile nature of the business. If a company’s balance sheet isn’t solid one bad game could destroy the company. Like what happened to Free Radical Design back in 2008 when it released Haze.

Valuation

Frontier is currently trading at a 1.1 times EV/Sales ratio which is quite low compared to peers. Peers trade between 2 to 6 times EV/Sales depending on Operating Margins. To be fair most of the companies on the list had much better operating margins than Frontier in FY2022.

Company	EV/Sales
Team 17(Ticker:LON-TM17)	3.8
Square Enix(Ticker:TYO-9684)	1.67
Embracer Group(Ticker:STO-EMBRAC-B)	2.1
Take-Two Interactive(Ticker:TTWO)	5.45
Enad Global(Ticker:STO-EG7)	1.27
Konami(Ticker:TYO-9766)	3.7
Frontier(Ticker:LON-FDEV)	1.1

Source: Chart made by author, data from company annual reports

Frontier’s low operating margins are depressing the company’s valuation compared to peers. Just last year when the company was reporting operating margins of 20% in FY2021 Frontier was trading at 6 times EV/Sales. 

Also the company has a couple of areas to increase revenue by cutting low hanging fruit. Such as making sequels to their older games and releasing their titles onto other platforms, and developing new content on their existing games. 

• Games such as Elite Dangerous and Planet Coaster came out in 2014 and 2016. Due to the age of the titles a sequel could make sense since both were successful games. 
• Both Jurassic Park Evolution and Planet Coaster saw sales boost after releasing to consoles. Planet Zoo doesn’t have a console edition. And Planet Zoo, Planet Coaster and F1 Manager aren’t on Switch(Not sure if F1 Manager would work well on Switch). Also none of the games are on mobile which I think some of them would work well.
• Elite Dangerous saw a significant sales boost after the Odyssey Expansion. Frontier could develop a large expansion to existing titles for their other franchises

Assuming my expectations for the stock are accurate then I should reevaluate the company in 2025 to see if their new slate of titles are worth holding the company further. 

Risks 

As a video game company I think Frontiers main risk is their new game risk. Making games costs a lot of money. Last year Frontier spent 46M in R&D costs which was 40% of revenue, not to mention the capitalized development costs. One bad game would wreak havoc on the company. Now what makes me confident in Frontier is that they have a track record making organic IP which have all gotten positive reviews, 72% of sales currently comes from their back catalog which insulates them from one bad new game, also the company has a pretty good balance sheet sitting at a net cash position. 

Conclusion 

Frontier is a tiny video game developer in the UK sitting on a depressed multiple due to profitability. I think coming around the corner we could see profitability inflect producing a higher multiple. The company has a solid balance sheet, good IP, a great track record in developing games, and high insider ownership. I think profitability will inflect around 2025 and if not I will need to reevaluate.