Enad Global: Deep Dive (OTCMKTS:ENADF)

Introduction

Enad Global (OTCPK:ENADF) engages in the development, distribution, and publishing of digital games. They have a portfolio with popular IPs (EverQuest 1 and 2, Planet Side 2, DC Universe, The Lord of the Rings Online, Dungeons and Dragons Online, My Singing Monsters and MechWarrior 5).

The business can be separated into two parts:

• The Games segment includes the creation of games and consulting assignments. They have rotated from an independent game developer to a work-for-hire business. This generates less risks and more predictability of cash flows, although, they want to continue to develop their own games. They use an 80-10-10 strategy, which means they use an already proven IP (80%) that has sustained demand in the market, they improve the game 10% and they introduce new characteristics (10%). This strategy is used by the bigger players to mitigate risk. They think they can utilize this strategy and create a space for their products in the middle-market.

• The services segment refers to consulting activities regarding development strategies and marketing of games and distributes games as publishers through digital and physically.

Investment Thesis

Alta Fox owned small cap with a portfolio of games that is very solid, management (which is new since 2022) has a very good track record doing M&A in the space (they are ex-PE). The diversity of the portfolio broadens the revenue stream and results in solid cash generation. The company aims to add growth by building game franchises on proven IPs from its own portfolio and external IPs. They target to generate $300M revenue and $100M EBITDA in 2026. Current market cap is $123M.

Business

They main source of revenues is the Game segment. They have well-proven brands (games) with 20 plus years of history on which they can build additional revenues. From this portfolio, the Company has built a pipeline of 3 games releases during 2024-2026.

The main challenge to this model is the limited players in the market that they have to attract to their existing games. Also, they plan to create new franchises with new games, they are of course unproven and the response by the market is uncertain.

They will have to reinvest into new venture or existing games to support any growth achievable by the company. They are at the point where substantial cash flows are being created and they can reinvest those cash flows into further growth: (between stages 2 and 3).

The Publishing segment was producing losses until this year. Its contribution should help the Company achieve their 2026 target.

Profitability is improving thanks to the product mix, but sales on existing games are overall constant/descending. They have just invested $15M in publishing rights for a game developed by a third party. This should improve revenues and profitability (due to scale) of the publishing segment with an exceptionally low risk of being an unprofitable investment. They will share a 30%-70% revenue share model with the developer.

According to analysts’ estimates, they should be able to finance all their growth with cash flows from operations and cash-on-hand (they have 35% of the Market Cap in cash) and no debt.

This is also evident from the earnings call where management said:

“Looking forward, EG7 reiterates its guidance for 2023 and the company is gradually ramping up investments to support revenue growth from new games with MechWarrior 5: Clans coming in 2024, the Cold Iron multiplayer action game in 2025 and H1Z1 in 2026. In Q3 2023, EG7 invested SEK83m in ongoing projects where the largest part, SEK50m, was related to the Cold Iron publishing deal where the company now has invested SEK81.5m while the total commitment is USD23m. While investments are ramping up, the company also continues to generate strong cashflow from operations (SEK113m in the quarter) and the net cash position stood at SEK358m in Q3 2023 which was largely unchanged compared to SEK361m in Q2 2023.”

Valuation

At first glance, the Company looks extremely undervalued even considering the unpredictability of revenues. Under no-growth assumption and a bellow average adj EBITDA margin we arrive at the following multiples:

The market is valuing this Company this cheaply because of the substantial risks they face. The digital games industry is a mature sector with some leading companies and a lot of smaller ones, like EG7, that are trying to develop new games that can generate good returns. It is all about content creation. This means developing new games and exploiting the opportunity to publish new games with a royalty fee. They are in a natural disadvantage against the big players because of lower development budgets.

The main source of revenue is their existing IPs. These are assets with limited lives in their balance sheet that can be exploited by them, through launches of new games editions, or through third parties paying a royalty to EG7.

Red Flag: Weird movement by management given their involvement in the latest investment. They are investing $23M into a deal with Cold Iron Studios to acquire the publishing rights of a game they are developing. In the deal, Cold Iron Studios have agreed to pay a Company co-owned by management and EG7 to develop this game, for a value of $8M. So net, they are investing $15M. The deal seems obscure to say the least given that management has some direct ownership into the developer.

How I would approach valuation

For these kinds of companies, finding the value at which you would have some margin of safety does not imply potential earnings as you will be betting on the unpredictable success of some development they make.

Their current assets have a limited life, and the business needs some reinvestment in order to guarantee some earnings in the future. I will look at it the following way

Value of their assets:

Looking at equity won’t help given high amount of goodwill.

Day Break: 8 operating IPs. They generate around $20M of normalized EBITDA per annum.

Big Blue Bubble: Their 1 game has increased popularity over the last 3 years. But normalized EBITDA before the popularity peak was around $2M per annum. Now they are at $34M, but we cannot expect this to continue, especially given the fast-moving pace of new content creation.

The rest of the Company are the developer’s subsegments. There are no valuable assets in them, and future earnings are unpredictable. The fast-moving environment of content creation can favor them, but every independent development (unpaid by a third party) is a significant risk until finding success/failure in the market. I believe a conservative valuation can be that the three existing subsegments dedicated to development can offset themselves to create no earnings or losses.

Petrol (publisher): Similar case as the developers. Earnings are somewhat predictable, and they have less fixed costs, so they have always been profitable, although almost no impact on the P&L (under $1M of earnings).

Atai Capital uses a base case of 5x EBITDA for the Company, so I am using the same for the subsegments.

These assets are producing between $20M to $35M of operating cash flows per year. Not bad at all, given it’s a 20%-30% yield on an estimated market value. However, this ignores substantial cash outflows that they have to deploy to maintain those cash flows.

Overall, this $107M valuation can go against what I think are the permanent capital requirements for the Company. These are all the cash outflows that are necessary just to keep up with the market.

Looking at the cash flows statement, we can see that the minimum required investment that has gone in over the last couple of years in order to grow and sustain current cash production is approximately $16M. They are being a bit more aggressive on their estimates, with an expected output of cash of $25M per annum for the next 2 years.

This will be achievable with their current operating cash flows and cash in hand (another $44M).

The main thing here is that the Company used to be overleveraged and has done an effort over the last two years to eliminate debt. The deleverage was the main catalyst for Alta Fox and Atai Capital to buy shares.

Outlook

Overall, we can arrive at the following outlook:

• Current assets will produce between $20M-$35M over the next 3 years, although their value will be lower with time. An estimate of $20M for 3 years is conservative.
• To sustain current earnings, the Company needs to deploy between $16M and $25M of capex. Management intends to do $25M to sustain growth.
• No more leverage, so no more financing cash outflows.
• $44M of cash on hand.

This level of capital deployment should maintain current assets ($107M) without losing value (capex includes growth above).

The valuation for the Company is $123M, so the market is currently seeing no value in the actions of the management team towards value creation. Any upside to current value must come from the growth efforts done by management (the extra $9M invested above maintenance capex). Management is shareholder friendly and is planning to return 6% back to shareholders.

The target in the image and the estimate of earnings for 2023 are very much in line with my predictions. $20M (100M SEK) of net income (+ $20M of non-cash items (amort.) = $20M operating cash flows.

Conclusion

The market is valuing their current IPs at market value ($100M-$120M) and predicting no growth for the value of these assets.

This also implies that current capital deployment by management will be unsuccessful. I do believe management can create value at some point in time, probably because they are overinvesting above maintenance capex to generate growth in their assets, but this growth is not guaranteed and is unpredictable.

Current value given the existing cash on hand is undemanding. Any positive outcome for the Company will result in a significant upside for the stock. The bad thing is that any value creation must come from development / M&A activity to acquire IPs, so the future for EG7 is highly unpredictable.

Any surprise above negative assumptions for the future of the Company will generate substantial returns for the stock, although is a tough sector where content creation is very capital intensive, and they are competing against the big players.

Important note: I am considering the latest balance (from 3Q), which does not reflect the value of their latest investments. There is $15M that has already been invested (in the partnership that I mentioned in the red flag) and that is yet to generate some return.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.