Chit Chat Stocks - Capcom (Ticker: CCOEF) | Not So Deep Dive

Episode Date: September 20, 2022

Capcom is a Japanese video game developer and publisher. The company has various product lines including video games, online games, mobile games, and arcade games. At the end of the month, we will publish an Arch Capital episode (only available to CCM+ subscribers) that will cover the company: Electronic Arts. Listen closely as Brad, Brett, and Ryan go through the history, financials, and future prospects of Capcom. Enjoy the show! Is this episode locked? Access our “Not So Deep Dive” episodes by signing up for CCM+. Sign-up directly through Spotify or Apple Podcasts. If you listen on another podcast player, use this link and create a private RSS feed: https://anchor.fm/chitchatmoney/subscribe Need more information? Check-out our launch newsletter: https://chitchatmoney.substack.com/p/welcome-to-chit-chat-money-plus  Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (2:08) Industry | (10:13) Management & Ownership | (13:03) Earnings | (17:13) Balance Sheet | (21:16) Valuation | (22:29) Our Analysis | (23:43) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. If you are listening to this, this is a CCM Plus only episode. So if you are subscribed on Spotify,

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Email us. It's part of the package. Today, though, let's get to the show. We're talking Capcom. We are continuing our gaming theme. This is one that's not going to be as well known as an Activision Blizzard, a Take-Two Interactive or an Electronic Arts in the United States, but is a Japanese gaming developer that has been around for as long or longer

than a lot of the gaming publishers out there. So Ryan, why don't you get into what Capcom does and some of the gaming brands listeners might recognize. Capcom is a Japanese video game developer and publisher. Over the years, they've introduced several popular franchises, but the ones people, well, the ones that drive the majority of the business today and the ones people recognize the most

are probably Monster Hunter, that franchise, guys. Resident Evil, Street Fighter, and Mega Man. I bet a lot of people maybe don't recognize the Street Fighter name, but if you saw the gameplay, this is something that was really popular on old console systems. It was kind of that one-on-one fighting graphics, that kind of display. If you look it up, you'll know exactly what I'm talking about. It's probably something you've seen before. But the bulk of Capcom's game sales today come from Monster Hunter and resident evil those are by far the two largest franchises in terms of cumulative unit sales so i'll kind of talk about those and dive into what those games actually are so monster hunter

in in the monster hunter franchise the user typically plays the role of a hunter that goes around trying to trap large monsters it's exactly what the name sounds like and they've built tons of different versions of this game since they first released it the most recent one is monster Hunter Rise. And the game itself typically costs $60 on consoles. It can get discounted as Capcom may want to do, but they also, users are able to upgrade their characters within the game through microtransactions. So kind of extends the life of the game, the monetization life, I should say, of the game. And then cumulatively, the Monster Hunter franchise has sold 84 million units since it was first launched and it's it's growing in popularity today the second one is resident evil

this is more of a shooter based horror franchise where the goal is basically to survive in a bunch of different environments and the game's typically filled with zombies the most recent version of the game is a remake called resident evil 3 i may be getting that wrong actually that there's probably i'll confirm the i'll confirm the timeline but they have a lot of remakes and stuff so it's hard to get uh it's hard to get it all under wraps they have like dozens and there's a lot of back catalog sales um with these franchises so even though there may be a new one that's really popular um the a lot of the old games will generate pretty good sales as well so uh cumulatively though uh resident evil has had more than 127 million units so that has been the

largest franchise on a unit space let me yeah let me correct that there is resident evil village which they do a mix of naming with numbers and naming with names uh so it's hard to follow the resident evil village was released in 2021 look up the reviews on that got a lot of great reviews but not much comparatively the commercial success wasn't as high and then in 2023 they're supposedly going to have a resident evil 4 remake uh so again another back catalog from what i can tell Well, Resident Evil does not have microtransactions as a part of it. It's really just you purchase the game, that's it. You go through the gameplay and then kind of you can probably play it multiple times.

There's probably a few different modes and then you buy the next one. So maybe it doesn't have as large of a monetization life as Monster Hunter. But outside of pure digital game sales, they also have a few other ways to generate revenue, Capcom does. So the first one is arcade operations. This is physical arcades located in various commercial complexes throughout Japan. And then the second one is amusement equipments. So this is like physical gaming machines, and it's a pretty small percentage of revenue that is next to ours. But they're selling physical gaming machines, and these have been declining over the last two years.

You kind of have to see pictures of it to know what I'm talking about, but it's not the arcade business. Those two things are separate. And then the third one is basically all other revenue sources, so primarily copyright revenue. This includes licensing their content for movies, TV shows, music, merchandise, esports, stuff like that. combined all three of those businesses. So the ones that are not digital game sales account for 20% of Capcom's revenue in 2021 or last full year. So the majority of the business, not only on a revenue basis, but operating income as well is driven by the actual game sales themselves. Also, all those businesses do generate positive operating income. It sounds like from management's

commentary that if one of those started to hemorrhage money uh they would probably uh stop stop feeding capital into it um as far as history goes capcom was initially started in japan in 1979 by kenzo sujimoto who is today still the ceo which brett will talk about and he funded the business with what's now equivalent to 70 000 us dollars at the time the company was called IRM Corporation, and it focused on developing purely gaming machines. And these were not video gaming machines. You could call them that if you want. But in 1981, IRM established a subsidiary called Japan Capsule Computer. So they had ambitions to potentially move to computer or software-based video games. But initially, their first video game... I shouldn't

call it video game. Their first game that they really launched was called Little League, and it was a coin operated arcade game so it was really functioned more like a pinball machine than it does like uh like a console game um and then they didn't actually they didn't actually produce a real video game until i want to say it was 1986 um when they released their first game 1942 for the nintendo entertainment system uh that kind of marked their shift towards developing for home consoles as well. And their first real hit didn't come until 1987. That was Mega Man, which is still a pretty popular franchise for them. Not their most popular, but that was their first real hit. And then throughout the 80s and 90s, and even still today, they continue to

develop not only games for consoles, but also arcade games and had a lot of success. They actually listed their shares for the first time in 1990 on the OTC markets in Japan. But some of their other successes include Street Fighter, as I mentioned earlier. That was initially started as an arcade game in 1987, and it's made, obviously, tons of sequels over the years. They also developed a Street Fighter movie in 1994. That's another theme that I should maybe mention is, I guess I talked about the licensing revenue, but they do make a lot of movies, whether that's them developing it themselves or working with outside parties to develop it. um resident evil was was first launched for the playstation in 1996 that too had its own movie and the movie actually generated more than 100 million dollars in sales worldwide and then the third uh franchise that i think is important to mention was monster hunter this was initially developed for the ps2 it's probably the youngest of the youngest franchise of some of the bigger ones that they have today this was uh first released in 2004 it won tons of awards in the

gaming industry and then obviously has gone on to sell tons of different versions but that's the bulk of the history um it's always nice to see businesses video game businesses that have had long-lasting franchises and not only long-lasting but ones that have grown their fan base over time that that test of time really can be sort of a testament to the durability of a game concept yep and some of them street fighter mega man have had durability but yeah monster hunter and resident evil have sustained or grown yeah and resident evil is a little more niche but yeah monster hunter has been very very strong which we'll talk about later in the episode let me hit industry and competition we've talked about it if you listen to the other gaming episodes but

total industry spending for the video game industry is expected to be about 178 billion dollars globally and then the console and pc gaming markets are around 40 billion dollars each uh in global spending that is you know 40 million dollars console 40 billion dollars pc and if we look at capcom they operate internationally and then when i say internationally i mean outside of japan so they have a large presence in east asia europe and north america and their focus is on the console and pc market and they also have their small subsidiaries uh you know the arcade and the the weird gaming stuff that they do but for the digital content for the video game part you know they are pretty internationally i don't know they they brag that they're in 200

countries which it's fine i don't know they they talk about that like 10 times in their annual report but again they're spread out around the world um one of the big takeaways i have from studying the gaming industry is even if the market uh like a certain medium say the console or pc or even arcade games looking back even further even if there's uh slowing growth or stagnation there has been strong durability from some of the older form factors now if we look at competitors pretty easy for a gaming publisher there's just all the other gaming publishers and the other companies that develop games for them for capcom you have nintendo who is also a frenemy because monster hunter rise has done extremely well on the switch you have bandai namco which that's another

japanese company i have trouble pronouncing that name i think it's uh bandai bandai i think it would probably be bandai yeah bandai namco and then there's square enix uh which might be enix um that's another japanese one then there's electronic arts activision blizzard take two interactive lots of other ones i mean it's again this is a very simple competitive landscape when consumers are looking to spend money on a console or pc game capcom was competing with all the other brands versus all these other companies uh you know with resident evil with monster hunter all the good stuff now lastly capcom has invested heavily in a strategy to increase digital and catalog sales to help improve operating margins this has been an industry-wide trend and it's

something i think any investor in this company should be tracking we're looking at capcom's financials that is both the percentage of digital sales which have higher margins than something you have to send you know uh that you have to sell in a box with a disc with a computer disc or whatever And then also the catalog sales. So that's for games. Don't know what their threshold is, if it's a year old, three years old or something like that. But older games, they're likely selling with that combination of digital where you've already made the game. You have really, really low invested, new invested capital needed for your R&D budget.

And you can sell those at even if it's $20. Those margins are really, really fat. All right. Let's move to management and ownership. uh like ryan mentioned capcom was started by current chairman sujimoto i wrote 1983 here i guess that was capcom but there was the uh other corporation that capcom kind of took over which was uh forget the name irm he still owns around four percent of the business he is actually as you might expect 81 years old so very very old executive and he explicitly mentions in the

annual report he's looking for a successor which will likely be one of his sons and speaking of his sons harry uh gosh i can't pronounce this name h-a-r-u-h-i-r-o harry hero yeah that's a tough one for an american to say um but he's the coo he's also the founder's son he is 58 years old he has been the coo since 2007 and he's been with capcom with the company since the 1980s so he's almost been there since the beginning working with the business sujimoto the founder he started this business maybe a little bit later in life i'm guessing well how old he would have been in his 40s i think so you know his son i guess he had a son early his son was there really he's been there for a long time he's almost a founder of this business he is definitely a

candidate to take over after kenzo leaves or passes away and then we also have riozo sujimoto that's spelled R-Y-O-Z-O he is the producer of the Monster Hunter series and he is one of the founder's son as well but younger he is 49 years old I would say another candidate to take over the business but probably the other one the older son

is the better candidate because he's been the COO the other one who's in charge of Monster Hunter has done extremely well that's their number one brand right now but he has just been a producer of that game the takeaway for me from looking at management The big one is that this is just a family business, and this is also a Japanese company.

So I had trouble finding a lot of executive compensation numbers. But given the corporate culture over there, I doubt compensation is an issue. Also, if you look at their share outstanding chart for the last decade or two, it is likely they're not using heavy stock-based compensation or any stock-based compensation because the only time the share count changes is when they buy back stock. Now, if we look at governance, 45% of the board of directors are true independent directors, which I kind of like. The company explicitly addresses the issue of a family business and says they want board members who are, quote, not intimidated by the company's founder. Now, whether that is just nice to say, or they're truly working to not have those issues that can come up with a family business or a founder that's been around for 40 years that has maybe

an iron fist control of a business, I don't know. But I like seeing that. I enjoyed seeing that and saw really no red flags when looking at the governance, the ownership or whatever of the company. Now, if we look at their capital return strategy, their goal is for a 30% dividend payout ratio. Their current yield is 1.26%. And they have a flexible share repurchase program that has been used steadily, I would say, over the last few years. I enjoyed both of those. I mean, maybe we would like to have it all in buybacks, but I do like a company that has a flexible buyback program that's not using it to try to make it seem like, oh, we're buying the dip on our own stock. They have it out there. They'll buy back stock when they think it's cheap, but they're

not going to just formally announce, oh, we have a billion dollar share repurchase program. Look at us. We think our stock is cheap. Lastly, an important note, they raised employee salaries by a healthy 30% in early 2022. Maybe they were underpaying developers. I don't know. But if so, I think investors should look for how this impacts margins going into 2022 because they spend a lot on R&D. Developers are a big chunk of their employee base. Also, check out the employee ownership table. Won't read it out, but pretty classic Japanese company here. Bank of Japan owns a big stake of this business check it out nothing too exciting but all of the uh sujimoto family they all own a stake here all right ryan do you want to hit earnings yeah and i'm gonna

talk in dollars they report in yen but i don't think it'd be i don't think we have a very big japanese listener base so chart yeah charts will be in yen just for comparison purposes but yeah all right so in the most recent full year they had 770 million dollars in revenue that was up a little more than 15% from the year before. In terms of segments, digital contents revenue, which comprises the lion's share, grew 16%. Arcade revenue grew as well, but that was kind of just a rebound from COVID.

That business is pretty stable. It's not really like a big grower, but it's pretty steady. Amusement sales, so those gaming machines, those declined. And then licensing revenue has been a really steady grower in recent years, obviously a small part of the business, but it's roughly double the revenue it was generating from five years ago. And it has 30% plus operating margins. It's not very expensive to license out your content. So they've been generating good operating income from those

businesses as well. But like I said, it's really dominated by whether or not they release games that are well-liked. And on the $770 million in revenue, they generated $300 million in operating income. That was up 27% year over year. 39% operating margins, really solid. That has steadily grown for the last decade. So 10 years ago, 2011 timeframe, they were generating roughly 15% operating margins. But as game distribution has gone digital, they've really seen the operating leverage from that and the reduced costs required to produce games. So it's gone from roughly 15% operating margins to almost 40% operating margins over the last 10 years. It's been really a sizable shift for the business. And then in terms of research and development, you talked about

developer expenses. They spent $210 million on research and development this year. That's 27% of revenue, but that is less than they spent on R&D in 2012. So they've really kept development expenses stable while growing their operating income. So they've done a really good job. I think that development department has done a really good job producing hit games on tight budgets. Now that did shoot up in 2022 relative to 2021. They said they expect it to be about, so they said it was $210 million this year. They said they expect it to be roughly that moving forward they want to keep it somewhat stable there we'll see we'll see you know they raise salaries uh we'll see but i important to track that number yeah they said they want it

to be 30 billion yen in moving forward in their 2021 annual report um but i also wonder how inflation on the yen impacts oh yeah yeah exactly i think definitely track it i think they're gonna have to backtrack some of those statements especially because they raise salaries by 30 They also report unit software unit sales. And so they sold 32.6 million software units this year. That was up 8% year over year. The software units has been growing steadily. Now it's kind of getting to the point where it raises the question, are those software sales replacing what would have been existing sales of physical disks? Or are they expanding the fan base? Because software sales are starting. Well, is it? Yeah, I think it's not. And I think that that would include physical discs. I know I didn't have the definition there for you, but that would be physical. This would be included. OK, well, up 8 percent. That's been steadily growing over the last five years. But the price they're selling those that they discount a lot of the catalog, they said they're not afraid to sell stuff for ten dollars. So, yeah. All right. Earnings, or not earnings, excuse me, valuation. Uh-oh, I just exited out of there. So, I got to bring back the-

Well, let me talk about balance sheet. Oh, yeah. Oh, excuse me. Yeah, I forgot balance sheet. So, balance sheet is really simple for them. They have $750 million in available cash and only $34 million in total borrowings. So, that's more than $700 million in net cash. However, as we alluded to, they hold that cash in the yen, which has collapsed 23% relative to the dollar over the last year. So they've been losing the value of the cash on their balance sheet over the last year, which is a real bummer because I think they could have allocated that capital elsewhere. I think they've maybe said this at points, but that's more than three years worth of their research and development expenses. So they could have three years of development without any revenue and pay for it out of their cash balance. So plenty of liquidity, but I would probably argue too much so.

And then they strive to pay out 30% of their net income and dividends each year, and they buy back shares periodically, as Brett mentioned. Like every show, I know it's sometimes hard to digest all the numbers listening to it. So go ahead and check out the charts that are in the Google Drive. It really helps me kind of conceptualize it. Yeah. All right. Valuation. That's next up here.

Based on a share price of $3,685, and that will be in yen. So it's the Japanese share price. They have a market cap in yen of about $785 billion. Enterprise value is down to $692 billion in yen. EV to sales, which is enterprise value divided by trailing 12-month sales. And actually here, we're just using the 2020 fiscal year 2021, which ended in March 2022. So their EV to sales 6.3, EV to operating income 16.1, and EV to operating cash flow of 14.7. If we take a look at their conversion from operating income to operating cash flow, they're low capex.

So I kind of like to use operating cash flow here as a good profitability metric for a gaming publisher. uh let's go from 2017 to 2021 conversion of operating income to cash flow we had 217 percent 109 98 42 109 so a little bit lumpy some years the cash flow might be a bit different just because of whatever it is game development uh however they're classifying it in an accounting perspective but typically the conversion is pretty good from operating income to cash flow all right let's move to anecdotal evidence what are your thoughts i know we don't play any of these games they're a little bit niche uh and more japanese focused but thoughts yeah i watched youtube videos on all the franchises i don't think i was uh i don't think i'm the target audience

for this uh for a lot of these franchises but monster hunter seems to have a lot of buzz a lot of people really seem to like it especially on the switch um it just did well did well yeah yeah it's done really well and people tend to really like the concept as for street fighter they recently did a 30th anniversary street fighter collection which was like all the street fighter games in one game and you can kind of like hop in from one to the next it kind of felt even though obviously there will always be sort of some fan base for Street Fighter. It felt like a last hurrah. Yeah, it's kind

of over with that one. The concept just doesn't really fit well into modern gaming. I think mobile, it would fit mobile. I would have thought that would do well on mobile. They've said

that they basically in financial document terms, we suck at mobile. So they haven't been able to do much. Yeah, I agree with that. All right. I mean, for mine, anecdotal, again, don't play any of these.

So hard to tell. But Resident Evil and Monster Hunter seem to have strong fan bases. They're not as big as some of the other franchises that we've seen from some of these global game publishers, but they're still strong. I do like their Disney-like strategy, and they explicitly mentioned Disney, trying to get their IP into as many different mediums as possible. um it seems smart but i think it's harder to do with their niche ip for example there's no way they could open up a theme park like nintendo did but they could license they could license

content to be a part of other people's theme parks yeah i i know it's just not i mean and technically if we want to get into the weeds someone might be thinking well nintendo's licensing to universal but it's it's a nintendo theme park like you couldn't have a capcom theme park there's no way you can't like what are you gonna have i mean it's not really a theme park well you could but no one would go um i just it kind of shows like yeah they can try the disney strategy but the brands aren't um they're they're good but not they're like second tier i would say um all right and that's not negative like it doesn't mean that they're the franchises can't grow but it's not as big as a grand theft auto a mario kart a fifa whatever call of duty all right

future growth opportunities what do you think you're running i think they they've got to allocate some resources towards mobile um i know they've they've basically said like we suck at mobile but they talk about it they talk about how they're going to yeah it's about 5g yeah they've done a really good job so they they implemented they recently implemented a strategy called single content multiple usage um and basically that was them honing in on their best franchises and really focusing a lot of their resources there and then trying to get a bigger fan base to adopt it and they've really done a good job expanding to every segment except mobile um that includes growth and licensing merchandising movies um and and then being sort of a hit on a lot of different consoles

but they've really sucked with mobile. I think it could be worth them buying a mobile studio. Guess what the company we're doing next week, Rovio, market cap, 428 million euros. That could be a good combination. Potentially, and that is predominantly a mobile business. Yeah. Yeah, I think you've got 700 million plus in net cash on the balance sheet.

I think, and you generate a lot of cash each year. they've generated cash every year the last since 2017 yeah more than 300 million in this most recent year in cash i think there's room to buy a mobile studio i don't think you have to sit there and say well we missed our shot and we can't do it but don't do it in-house it's just not gonna work you need someone with the expertise rovio we're gonna be covering and maybe we're gonna get to them and say oh this is a shit studio but they made angry birds and i think that you know that that uh experience could really really help same it's like i don't know it's just it's the same as like uh going into movies or trying to develop a console game you have to know what

your core competence competency is and we're gonna i guess talk about that later but um it's a lot harder than you think to go from one sort of gaming or entertainment medium to another all in mind though and it's really a simple one for a game publisher there's not much not much else It's new franchises in order to hit their 100 million software unit goal, which they have the short term goal of 50 million and then the long term goal of 100 million units annually. They're going to need to either bring Monster Hunter to the next level, quote unquote, or make it and make it a global franchise, or they're going to need some of these new franchises that they're developing to get in the mix. I mean, catalog sales can really only take you so far. And I feel like they've juiced that a ton the last decade. smartly but you know the easy uh money has been made to use that cliche with that type of stuff

now they have two things in the works that they've mentioned they are releasing a sci-fi shooting game called exo primal in 2023 well kind of interesting they're also releasing something called pragmatic which is again weird uh it's a dystopian lunar based game so moon based game again kind of seemed cool but who knows when if these will be hits but capcom is getting some shots on goal we'll see they're also obviously developing stuff for resident evil and monster hunter as well with the size of this business even if they add one more of these franchises that does say five million unit sales a year that could be a and especially if their r&d budget's the same it could be a game changer with the operating leverage that could kick in here

a lot of that um revenue could flow down to you know cash flow all right let's hit highlights and lowlights ryan what'd you like and dislike about this business well i talked earlier about Well, something that I've kind of grown to look for in video game companies is franchises that have lasted longer than a decade. And then especially franchises that have lasted longer than a decade and have a larger user base or a fan base than they did 10 years ago. They've got a couple of those, Monster Hunter, Resident Evil. I think it'd be hard to argue that Street Fighter has a bigger fan base. Definitely not, but yeah. But I really like when I see that because you know there's some durability with the business, some predictability, and that's definitely a positive.

The other one is they've done a really good job getting a lot out of their developers, given that the development budget has actually shrunk over the last 10 years. maybe that changes a little bit here in this next year but i think generally they are very cost conscious um and they've done a really good job driving better and better income for their shareholders it feels just generally like a shareholder friendly company yeah they're good with expenses that are compared to maybe some of the american gaming publishers where you're like what are you spending money on now if we look at the charts uh that will be in the sub stack google drive they are only spending uh i did not get the definition of this but i think it's just marketing expense oh gosh where is it where is the promotion promotional expense uh as a percentage

of revenue aha here it is in 2017 it was below six percent in 2021 it was below four percent i wouldn't even mind them bumping that up to 10 if they can do it smartly because it seems like some of their games just aren't getting the marketing budget as the larger ones and they have the the cash and the balance you do that if they want to grow their software unit sales i would not mind i would not mind just an increase in marketing spend it obviously if it has a good returns but it feels like that's a really really low spend um as a percentage of their revenue yeah um low lights for me though i think a large chunk of the operating leverage that we've seen over the last decade just kind of came obviously they had to do some work to develop games for

digital distribution but i think a lot of it just came from the fact that most people buy games online now and they don't have to have physical production and so that that really is probably a lot of low-hanging fruit for them um and they're getting to the point now i believe it's upwards of 80 of their sales their unit sales are digital so i think it's getting to the point now where they're kind of bumping up against that ceiling and maybe they're not going to be able to recognize a whole bunch of operating leverage from that. I wouldn't be surprised if they hovered around their current operating margins. I want it. If, if I'm buying the business today,

it's probably not because I think there's going to be a whole lot, a whole lot more operating leverage. We're going to need to see the top line kicking, which has been a bit, not as great. The top line growth. That's my, yeah. Just an overall lack of sales growth. the last decade it's basically i want to say pretty much flat over the last 10 years depending on what year you choose and that's in yen so there might be some weird stuff there but still i mean and then lastly they're far too conservative with the cash i mean they lost a lot of value

for shareholders this year just holding that holding that cash and yen oh yeah it's going to happen in the future but there might be someone here listening from japan the one listener but for you i mean we're kind of u.s investor focused so that's where that's where our mindset is yeah just a little too conservative i know that's kind of japanese uh corporate culture but uh i would like to see them be a little more aggressive either on the buybacks or um buying out studios or maybe spending more in promotional expense or development expense yeah or just give us a special dividend uh i don't know not us we're not shareholders either i don't want it to sit again on the balance sheet yeah yeah all right i'll move to my highlights and the i like the

execution of the catalog and digital expansion strategy they you know we said we kind of said that that juice maybe there might not be that much juice left in that but they've done really well i mean these are the two reasons why the capcom's operating margin has expanded over the last five to ten years and it's why the stock's much higher second highlight the execution of the monster hunter series over the last few years has been great so monster hunter world has hit 21 million unit sales and monster hunter rise which is the switch and pc game um has hit 11 million unit sales when the next flagship game comes out likely within now who knows with gaming within the next five years you know will it be able to hit that next step change and sell 30 to 40 million units

um maybe who knows i think it's possible but that could be the big growth driver driver for them i think another benefit i'm just kind of thinking of this now of them selling their back catalog so cheap uh or at significant discounts smart that's the marketing right there yeah it just brings in new users for the next uh game release which maybe that's been helping them uh with uh with monster driving units yeah yeah yeah i agree third highlight management's long-term tenures and long-term focus has been great i mean when reading their shareholder updates i love their mindset yeah you know sujimoto is um gonna be out of here soon or at least maybe who knows i guess some people go for a long time in the executive role but they

talk about the succession plan um i love their mindset i think they truly are you know they they understand how to be stewards of capital and that gets used around i guess tossed around way too much but they definitely understand it um i think few minute few management teams actually do lastly the consistent share repurchase program could be more aggressive, obviously. However, their cash balance really hasn't grown until recently, which is a good sign because the company is generating a lot more cash now. So maybe we're just being a bit impatient looking at this, and maybe they're going to have a better capital return strategy. However, when I looked at... They said their old goal was to hit 100 billion yen in cash, and they hit it. But then they

mentioned oh actually we might actually want 200 billion yen and i was like oh my gosh kalasic japanese company let's go guys and that's this is plenty for the size of their business now low lights um just like ryan said lack of consistent top line growth don't need to hit that other one we haven't hit is they started capcom pictures in los angeles apparently they're going to produce their own movies now or television shows um this feels risky and not the best move really i don't think they're going to succeed yeah i'd rather see them license their ip however you know there's some upside there but i would hopefully they're not going to waste a lot of money that's just kind of my thought um other low light they have a history of letting franchises

die we talked about street fighter fighter we talked about mega man a little bit less durability than some of the other gaming franchises out there at least from the same sort of relevance perspective i worry about that if that happens with resident evil if that happens with monster hunter i mean those are their two cash cows uh other one we talked about mobile don't need to hit that again balance sheet too conservative already hit that so let's move to bull case ryan what do you think has to happen uh to go right here well they got to expand their fan base over the next five years i think the the real uh concern well i'll save the concern for the bear case but uh if they expand their fan base and they're able to maintain uh software unit

sale growth of let's say high single digits um i imagine that eventually almost all game sales go digital so maybe there's a little operating leverage left um in terms of distribution I think there's a chance that they can hit that goal, or it's probably likely. If they get high single-digit unit sales growth, it's probably likely that management will hit their medium-term goal, which is 10% annual profit growth every year. That seems fairly likely, and I could see them sustaining the current valuation. It's not too crazy, but I think this is kind of a business that deserves a cheaper multiple. than maybe some of the more

proven franchises. Yeah, some of the Japanese stuff and less it just doesn't have that sports monopoly as you might have for an Electronic Arts, which we'll talk about. That is going to be our last gaming episode, so we'll go through the case study on that. And they've shown that some of

the franchises can die. That's true. And that happens to every publisher, but some publishers have way more franchises. Yeah, if I'm picking we kind of did this exercise the other day if I'm picking what franchises

gaming franchises I am really damn sure will be around in 10 years Monster Hunter and Resident Evil probably aren't at the top of my list yeah and Resident Evil has been around since 96 it's pretty good I'd say

that's decent they have a really really good niche Monster Hunter yeah definitely no way though um but it could it could it could it's just yeah it's just not a cinch like a mario kart um yeah my bull case is we are underestimating the catalog and digital tailwinds and they continue a little bit more than we might think over the next five to ten years you know this drives the baseline of annual unit sales up to maybe the 50 million range and then operating margins inch a little bit higher then if you have the growth of the new monster hunter game and add in some of

these new titles either pragmata or exo primal uh do well that's pretty simple the games do well they're going to do well i mean given the operating leverage on their r&d budget given the valuation it's not an aggressive valuation we're not pricing in a successful um or you know we're not pricing in monster hunter taking the next step and we're not pricing in one of these new games being successful given the valuation you'll likely do really really well here if those targets are hit i always try to come up with some sort of a creative bull case but ultimately for this business it's literally it's literally do they make better monster hunter games or better resident evil games than they have previously does it expand the fan base if they do that or if they

can have i don't even franchise yeah i don't even know how important resident evil is i think monster hunter is the key here just given the size of it now resident evil is a little bit smaller but i mean it's still important that it sticks around yeah and it kind of gives me a little bit of a feeling of margin of safety as a potential investor yeah like if we look at resident i was looking at resident evil village uh reviews because i was like why are the game sales not as good anymore um really really strong reviews uh where's metacritic we saw like someone said oh this is maybe the best president evil of all time it's certainly up there with the best of the series like people go in an 83 and metacritic pretty strong there it's just not going to be as

commercially successful just because of that uh i'm pretty sure category also no i don't think there's a live services component and they're they don't focus on it as much either which is again a downside on the predictability if yeah maybe it preserves that nostalgic factor for your really hardcore fan base which resident evil seems to have and they don't hate you like you fans yeah but it just you know live services i think helps drive network effects helps drive greater adoption um and it keeps people more engaged for longer yep uh something like you know fortnite there's classic examples there now let's move to bear case what do you think go wrong here ryan uh if they don't i think at some point in the next five years they gotta have a successful

new franchise it's been a while since they've had one or if just the monster hunter business doesn't grow um i think yeah you need growth those are going to lead to uh any sort of decline in unit sales is probably not good for this business um i don't know or maybe they're really close to the ceiling on digital sales so maybe there's no operating leverage there uh so really if they don't have top line growth this business is not going to this is not going a good investment yeah that's kind of same with me i think it's very simple uh bear case is the stagnation of you can lose money i think if there's the stagnation of the monster hunter franchise um and then these new game developments being flops which are you know definitely out there

a lot of it's kind of like restaurants a lot of new games uh concepts fail most of them fail for the last 10 years they've been able to seriously increase their operating profit while not growing sales at all that can't last yeah that's that's thing the easy like i said it's a cliche but i honestly the easy money's been made with for that business for this business um but yeah i mean the business just looks like it's set up for the bear case to be it running in place like i doubt the new monster hunter will be a flop i really doubt it but if it doesn't grow its fan base i mean you're trading at 16 times earnings operating earnings not even post uh taxes yeah i mean you probably don't lose money it as long as monster hunter doesn't go away but

i don't see a way again and you're in yen you have the japanese risk here now let's move to more or less interested to wrap thing up ryan what do you think final thoughts here i'm less interested it it's hard for me to like pin pin it down on one thing but i just don't like for one it feels like the entire thesis is pretty much predicated on a single franchise here i tend to not like that because especially because there's kind of a hit or miss nature with these games as opposed to something that's almost like a software update like well not only pushed back monster hunter is at a pretty strong track record i would say that's not i don't know if it's a coin flip for them to have the next game be successful at the sacrifice of all their other

franchises kind of dwindling yeah that's true and they've they've said that they're focusing a lot of their resources on their core competencies or their their core content that is done really well so if they're just sacrificing all their other franchises to have a ton of success with monster hunter i don't know that that feels like a big risk to me also japanese yeah a little it's not like that's not i do not mean that it's just the japanese yen and the culture there is just tougher they don't it's really discouraging to look at a business look 10 years back and see no sales growth yeah exactly like it makes it really hard to buy in yeah well buying at a valuation above 10 times earnings now i think that leads into my more or less interested and it's more interested

but definitely not at this price i think their execution over the years they've been around for 40 years um some of the franchise has been around for almost that long the catalog and the digital sales and their distribution strategy for pc and consoles i think that's you know fairly durable however i'd want to pay uh not i don't want to pay given their lack of historical growth i would this just feels a bit expensive for me yeah you'd have to pay something real cheap but i still like i mean game publishers are profitable for a reason we looked at this one they have 30 margins or 40 margins we look at a lot of other gaming publishers they have high margins We don't really calculate return on invested capital,

but they have strong returns on invested capital. However you want to calculate it, I can almost guarantee it. That's why I'm interested in these companies, but just not at this price for Capcom. All right, stock for next week. We are going to be discussing Rovio Entertainment as we teased. That'll be the last one in the gaming series before we do the company we own, which is Electronic Arts.

And I think those are going to be coming out during the same week. If not, really, really close together It'll be Rovio Entertainment And they're the maker of Angry Birds So get excited And they're from, I think, Finland But I could be getting that wrong We'll know for sure next week

I've looked at them once before They look pretty interesting It is interesting And the stock is down So it could be fun Alright, that's going to do it for this episode Thank you all for listening and subscribing Remember the email thing

Confirm it for the drive and the sub stack Everyone should get all that access We don't want you to not have that Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you all for listening again.

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