CD Projekt Q2 Earnings: Still a “Show Me” Story (OTGLF)

CD Projekt (OTCPK:OTGLF) (OTCPK:OTGLY) may have added to its “Witcher” gaming IP series with the recently released AAA title, “Cyberpunk 2077”, but its finances have been mixed. The second quarter was more or less the same, with annual revenues and profits are falling despite efforts to cut costs. The biggest disappointment of the quarter, however, was the announcement of the “Cyberpunk 2077” expansion, with the direction guiding towards a single paid downloadable content (DLC) pack for the game through 2023. That seems a rather disappointing result to me. , given the untapped monetization potential. and the considerable time lag from the AAA game’s next release (likely after 2023).

Additionally, CD has yet to address its consistent delays for new product releases (e.g., the multi-quarter delay of next-gen “Witcher 3”), leading to investor skepticism about its ability to recover from creative obstacles all along the line. While the stock price has been beaten since the start of the year (now at multi-year lows), the valuation multiple remains at a premium of around 35x the current P/E and could come under further pressure. Until visibility on improving AAA game development using the new engine (Epic Games’ Unreal Engine 5 technology) and the next strategy update in October, I would stay away.

Another quarter of annual decline

In Q2, CD recorded ~ZL1.62 million in revenue, down 41% YoY from a strong 2021 base and a worrying decline of around 25% QoQ. Given the advantage of the weaker PLN, which depreciated >15% YoY against the USD in Q2 2022, the disappointing revenue result likely also implies lower “Cyberpunk 2077” copies. Echoing the first quarter of 2022, additional detractors include the continued decline in revenue from GWENT (i.e. “The Witcher Card Game”) following the termination of the consortium agreement, the decline in revenue from the digital store from new releases due to launch delays and the suspension of CD operations in Russia and Belarus. .

Despite revenue headwinds, CD increased Q2 EBITDA margins by ~6% YoY on lower “Cyberpunk 2077” service costs (~ZL18m depreciation recognized during of the quarter under the revenue cost line). While SG&A cost reductions also helped margins, CD’s reported net profit of ZL44.8 million was still down -51% on an annual basis (-35% QoQ). In turn, its operating cash flow also disappointed at ZL0.5m, impacted by high cash taxes as well as a QoQ acceleration in new project spending to ZL62m (from ZL28m). ZL in the first quarter of 2022). Overall, the net cash position decreased slightly sequentially to ZL 1.18 billion, although the ability to pay dividends remains intact (recall, the company paid > PLN 100 million in dividends in July).

Short-term orientation offers little joy

Worryingly, CD management is seeing continued salary pressure in the coming quarters as changes in post-COVID work preferences create new challenges for talent retention. In particular, developers are increasingly able to work from Poland for higher global salaries, creating upward pressure on CD’s salary structure. That said, the company also sees opportunities to hire overseas – quality is a big concern here, but if successful, CD could see some labor inflation offset while building capacity. to develop more AAA titles in the future. Management guidelines have already pegged 2022 salaries at last year’s levels at around 23%, so the bar is not low.

On the revenue side, CD cited a limited impact on sales so far amid weaker consumer/macro spending, although the continued sequential decline in revenue and earnings remains a concern. Additionally, the impact of the suspension of its operations in Russia and Belarus will remain a headwind for YoY comps throughout the year. There will be a strategy update in October, but given the uncertainties my base case does not foresee any major changes from the previous one, although additional color on key issues (e.g. new system incentive) would be welcome.

Cyberpunk Expansion Slowed Amid ‘Unreal Engine’ Transition

Along with the earnings report, CD also announced Phantom Liberty, the first “Cyberpunk 2077” expansion, slated to launch in FY23 on next-gen consoles and PCs. Management sees this as an important step to support long-term sales of the “Cyberpunk” title, devoting most of its development capacity to expansion. Even though management calls it a major expansion, the price remains undisclosed, so it’s hard to determine the specific revenue opportunity here. On a positive note, the launch of the “Cyberpunk 2077” expansion pack will see a boost on the media side, with a new Cyberpunk anime series coming to Netflix in conjunction (created by CD and Japanese studio Trigger). That said, the company’s plan for just one big expansion pack in 2023 leaves a significant gap between product cycles and is therefore a disappointment on the monetization front.

For context, one of the main reasons for the limited release schedule is the company’s move from its in-house game engine to the Unreal Engine 5 platform. Future games, including the next addition to the Witcher saga ( currently in pre-production), will use Epic Games’ Unreal Engine 5. In the long term, the transition should pay off – the advanced capabilities of the new engine will not only enable more efficient development but also make it easier to attract and retain new talent. Thanks to the strategic partnership with Epic, CD will also be able to exploit Android for its future games, effectively reducing the risks of the development process (a sore point so far). In the meantime, CD development issues continue – after suffering numerous delays since the initial Q2 2022 launch, the next-gen version of “The Witcher 3” (free for players who already own it) is now slated for launch in Q4 2022.

Always a “show me” story

CD’s lackluster financial performance in the second quarter aside, the outlook for its next-gen console content remains far from rosy, even with upcoming ‘Cyberpunk’ updates and the next-gen ‘Witcher’ edition. . While the new expansion pack is a step in the right direction, the limited content mailing list is a short-term concern, especially given the scale of the planned investment. Additionally, the monetization of “Cyberpunk 2077” was disappointing, failing to bring the CD back to its previous expectations on units sold. Upside development over the pending Unreal Engine 5 platform transition should also be treated with some skepticism, in my opinion, due to CD’s past runtime issues and difficulty in attracting talent after COVID.

The share price has been downgraded to multi-year lows accordingly, but its P/E valuation remains at a premium. This makes it vulnerable, in my opinion, to further decline in future execution delays or disappointments in the strategy update next month.