Sega: Value In Video Game’s

Introduction

Sega’s video game business is being overshadowed by declining business segments, but underneath we have a growing profitable business. This overshadowment is creating one of the cheapest video game plays out there trading at an adjusted 8-12 PE ratio. Sega has a huge cash pile with great IP and good growth potential due to development of a new big game, acquisitions and utilization of existing IP. 

As the beautiful chart above indicates; since 2014, Sega sales have been flat to declining. Looking even further back, sales have been declining since 2005. This is due to having many business segments in structural decline. Sega has four main business segments with three of them in declining industries. However the video game segment is the diamond in the rough.

Slot and Pinball Machine Business

Sales in their slot machine business peaked in 2005 achieving 280.1B Yen in Revenue last year it generated 53B in revenue. The number has some COVID distortions and this year they are projecting 89B in sales. The player population in Japan has declined since 1996 from approximately 27.6 Million to 8.9 Million. Around 2012 the player population seems to have stabilized around that 8.9 million mark. However, the number of slot machine operator halls in Japan is still declining at a 2-4% speed and the trend continues . After recovering from the pandemic , the business will continue to decline at a rate of 2-4% a year. The one saving grace is the operating income margin which is positive and ranging around 11-23%.

Amusement Machines and Amusement Centers

This segment which is the sale of arcade machines is also in a slow and steady decline. For example, sales in 2005 were at 63.3B Yen. This year it is forecasted to be around 43B Yen. The number of players has declined from 22.7mm in 2005 to 15.3mm in 2018 per Sega’s 2019 Annual Report. This segment unlike the slot machines has no saving grace as the operating margin fluctuates between -4% to 3%. Sega also manages over 200 arcade centers in Japan which was also a declining segment with little to no net income in a given year representing a little more than 10% of sales. I bring up this small segment because Sega sold the business in 2020. The amount was undisclosed, but any cash is good cash this gives me hope that Sega seeks to further monetize their declining segments to feed their future.

Resorts Business

Since 2012 Sega has dipped its toes into the casino resorts business and owns two resorts one in South Korea and another in Japan. This is a very small part of their business; however, management does seem keen to expand it. Japan recently legalized gambling in 2018 before that Japan was the only G8 country to not have gambling legal. Legalization brought with it 3 casino licenses to be built in 3 different cities. That means gaining a license could be rather lucrative because you’ll effectively be a monopoly in your region. Recently, Sega submitted one of two proposals to operate a casino in Yokohama City, the second largest city in Japan. Sega was prepared to spend their entire cash balance on the new casino of 135B Yen. Due to a recent city election the new mayor is opposed to any casino; so it’ll probably be scrapped. The other licenses have already been bid on and won so it looks like Sega’s casino dreams are dead. What is left of this business segment is two small resorts losing 2B Yen a year.

Video Game Segment

The one growing business for Sega and the business that has the most potential is their video game segment.

The video game industry in general is projected to grow according to my own projections by a 5-11% CAGR for the next 20 years. This is backed up by Grand View Research which is projecting a 12% CAGR up till 2027.

Source: Grand View Research

The video game segment for Sega has been growing at a 9% CAGR since 2016 compared to an overall sales declining at a -4% CAGR. Video game sales to total sales has increased from 25% in 2015 to 48% in 2021. As video game segment sales have hit almost 50% we should start to see sustained sales increases from here as the video game segment grows faster than the declining segments. Finally reversing that total sales chart from above. Sega themselves is forecasting 233 Billion Yen in revenue from their video game segment by 2024 which represents a 20% CAGR.

Sega’s Video Game Segment Factsheet

Sega’s video game operating income margin has expanded dramatically from 2% in 2016 to 23% in 2021. This is partially due to Sega’s own efficiency measures and digital sales becoming a bigger portion of total video game sales. Back in 2016, digital to package game sales was around 50-50; but, due to COVID digital sales has increased to the 60-70% range. This should continue into the future and margins should sustain around the 15-20% range.

IP

Sega controls some great IP as I mentioned above, this includes Sonic, Phantasy Star Online, Total War, Persona, Football Manager, Humankind and Yakuza franchises. Sega’s biggest IP can be inferred from the slide below Sonic, Total War, Football manager and Persona are Sega’s biggest franchises. Sega’s revenues are diversified across these various titles rather evenly and isn’t to dependent on any one of them.

Sega was recently named Metacritics 2020 game publisher of the year due to successes like Yakuza: Zero and Persona 5 Royal. In the table below I list Sega’s last two releases for top franchises as it relates to sales. Sega is hitting in the 80’s consistently for almost every release on metacritic. This shows Sega knows how to make a good game and bodes well for the future as Sega seeks to create a new super game.

Super Game

The first area for Sega’s future growth is their super game aimed to take 3-5 years of development, this most likely FPS game is a good choice since Sega has no major title in this category. The FPS is set to drop before 2024. Whether they’ll be able to create an online global FPS that can compete with Call of Duty and Battlefield is unknown. Other large titles out on the horizon would be Persona 6, Total War Warhammer 3, Lost Judgment and Shin Megami Tensei V. Also in Sega’s May 13 2021 earnings call they mentioned that their internal studio is developing 2 more titles aimed at being super games. These new super games as Sega calls them are instrumental in Sega’s forecast of a 20% CAGR over the next 3 years.

Acquisitions

Sega has actually been pretty good on the M&A front. Creative Assembly, the studio behind Total War, was acquired in 2005 and Sports Interactive Ltd, the studio behind Football Manager was acquired in 2006. Sega’s latest acquisitions include Amplitude Studios and Relic Entertainment, companies behind great IP like Company of Heroes and Endless Space. Both games have very positive reviews on Steam with games before and after the acquisitions. This proves that Sega can make good acquisitions and not get in the way of the acquired studios. With 135B Yen or around 1B USD in cash Sega should have ample dry powder to continue to make good acquisitions.

Utilization of Existing IP

Sega has plenty of IP that they can remaster, remake and reboot. Persona 4 Golden is one example of a game that originally released only on PlayStation the game was rereleased on PC last year to overwhelmingly positive reviews and with close to 50,000 reviews it isn’t hard to imagine with only a minority of buyers posting reviews that the game got hundreds of thousands of downloads and millions in dollars in revenue just porting a game from PS4 to PC. And Persona 4 isn’t the only one with such results; the other Persona and Yakuza games had similar results. This adds another easy way to generate growth for the future.

Valuation

If you assume that only the video game segment has any value then right now you’re paying around 3 times sales multiple and a 20 times earnings ratio both which is one of the lowest in the industry. 

Video Game Stock Multiples

Company	3YR AVG PM	PS Ratio	PE Ratio
Paradox(PDX)	0.22	9.68	44.60
Activision(ATVI)	0.25	7.95	31.62
Electronic Arts(EA)	0.30	7.44	24.54
NCSoft(036570)	0.22	7.02	32.33
Keywords(OTC:KYYWF)	0.09	6.67	74.86
Nexon(OTCPK:NEXOF)	0.44	6.46	14.78
Take Two(TTWO)	0.25	5.36	21.58
Capcom(OTCPK:CCOEF)	0.25	5.13	20.53
Netmarble(251270)	0.09	4.56	50.54
Nintendo(OTCPK:NTDOY)	0.25	3.51	14.31
CD Projekt(CDR)	0.03	3.15	120.32
Konami(OTCPK:KNMCY)	0.07	3.12	42.08
Square Enix(OTCPK:SQNXF)	0.05	3.06	64.08
Ubisoft(OTCPK:UBSFY)	0.04	2.97	75.09
Sega(6460)	0.14	2.94	21.33
Digital Bros(DIB)	-0.04	2.53	-71.05
Gravity(GRVY)	0.12	1.89	16.39

However a 20 P/E ratio isn’t that attractive in isolation. This is where incorporating Sega’s massive cash pile and trying to value the other businesses make Sega the cheapest gaming stock out there.

Sega Valuation in Japanese Yen

The market cap of Sega is around 400B Yen. Once subtracting the cash pile and the value of the other businesses the new market cap is 174B. I chose to estimate the value of the other businesses with a conservative .5 sales ratio due to there declining nature and around a 7% combined operating margin. Since Sega’s projections for the year 2022 ending March, sales is 312B Yen and 140B are video game sales, the other segments will contribute 172B Yen in revenue.

Sega last year achieved over a 20% Profit Margin in their video game segment, however I used a range of profit margins as I think the true margin for Sega will hover around 10-20% in the future, with 20% a peak profit margin and 10% a trough profit margin. Being conservative this means at the current price of 1500 Yen we are getting Sega’s video game business between a 8-12 PE Ratio. Which makes it the cheapest gaming stock in the fast growing video game industry.

Sega’s video game segment has been growing around 9% over the past 5 years. I’m expecting Sega to grow inline with the industry which falls between 6-11% growth in the years to come. Sega also has the optionality of nailing one of there “super games” which could provide sustained growth higher than the industry somewhere around the 15-20% area. Either way Sega is trading at a close to or below 1 PEG ratio which I find very attractive. As Sega’s video game sales become a bigger proportion of total sales this should close the valuation gap between Sega and peers.

Risks

– Sega not able to execute on there super game.

– Quality of IP measured though metacritic scores dip.

– Management wastes cash pile though unwise acquisitions.

– Declining business segments decline faster than projected and Sega is unable to monetize for as much as I projected. 

Conclusion

The video game industry is a fast growing industry for years to come. Sega provides the best value in the industry. Sega has great growth potential due to new hits, acquisitions, and utilization of existing IP. I rate Sega a buy.