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Top-pick for 2011: G5 Entertainment

The company:
G5 Entertainment is a company specialised on app development with focus on casual and time-management games for the Iphone, Ipad and Mac. Apps for Android are expected to be launched during 2011.
G5 Entertainment started as one of the world’s leading mobile game development studios, developing games based on popular licenses for Electronic Arts, Disney, THQ, Konami and others. Since 2009, G5 Entertainment is developing and publishing downloadable games of iOS, PC and portable game consoles. G5’s portfolio includes popular casual games like Supermarket Mania, Virtual City, Stand O’Food and Mahjongg Artifacts. G5 also develops games based on third party licenses and publishes games developed by third party developers – in both cases on revenue share terms.

The industry:
The global app market is growing strongly both for Apple’s Iphone and Ipad but also Android. First of all this is caused by an ever growing base of devices. In a recent article, Swedish newspaper Dagens Industri wrote about a Morgan Stanley report saying that it expects the number of sold tablets to grow from 16 million in 2010 to 55 million on 2011, 85 million in 2012 and 102 million 2013. On top of that, Apple continues to sell millions of iPhone’s each month (in its Q1 2011 Apple sold 16.2 million iPhones and 7.33m iPads). So the underlying market for apps is growing steadily.

The case:
The company is still small but is growing impressively and is sitting on a net cash position. In 2010 sales reached SEK 22.75m and EBIT of SEK 9m, implying a very strong EBIT margin of some 41%. In connection with its Q4 report published in February 2011, the company guided for 2011 revenues to reach SEK 45m, i.e. an increase of almost 100% year-on-year. Management also guided for an EPS of SEK 1.9 in 2011, up from SEK 1.01 in 2010!
These goals seem ambitious at first glance, but G5 Entertainment has in the past always managed to exceed its targets and the business model gives rather good transparency making revenue development more predictable.
During 2010, G5 Entertainment released a total of 27 games, compared to only 9 games released in 2009. The group aims to release 80 more games in 2011, including games for Android. At the end of 2009, G5 Entertainment had a portfolio of 17 games. At the end of 2010 – a portfolio of 44 games. With the release of 80 games in 2011, G5’s portfolio is set to grow to over 120 games by the end of 2011.
The beauty of it: The games published 2 years ago are still generating substantial income, without adding any additional costs. In February 2009, G5 Entertainment released its first iPhone game “Supermarket Mania, which became a success on the App Store. In March-May 2009, there was a substantial peak of sales for the game, and then revenue settled on a stable off-peak level. In 2011, Supermarket Mania for iPhone generates the same level of monthly sales as in 2009 after the peak! Other products show similar patterns. G5 Entertainment capitalizes development costs during the development of new products and depreciates the cost evenly over 2-year period following the release of the game. As of Q2 2011, 100% of the revenue generated by Supermarket Mania for iPhone will contribue directly to profit, as it is no longer to be offset by depreciation of the development costs – talk about margin booster!

You can follow the rankings of G5 Entertainment’s games in the different app stores on:

The valuation:
G5 Entertainment’s share is currently trading at around SEK 24 per share. The stock market is always forward-looking so we are only interested in expected earnings. Management’s current EPS guidance of SEK 1.90 per share for 2011 implies a PER of 12.6x – a bargain for a company that is growing its earnings by an expected 90%!
There are not many app developers listed on the stock exchange but we have found two of them. French Gameloft and American Glu Mobile are also developing gaming apps but their profitability is either much weaker compared to G5 Entertainment (in Gameloft’s case) or non-existing (Glu Mobile).
Nevertheless, Gameloft is currently valued at a PER of around 22x expected 2011 earnings. It is a bigger company than G5 and followed by several French analysts so estimates are readily available. Since Glu Mobile is still loss making (analysts expect this to continue into 2012) it is not possible to look at a PE-ratio. In order to also take the balance sheet into consideration we can look at EV/EBIT valuations as well. Here the market values G5 Entertainment at some 11x its expected 2011 EBIT. Analysts expect Glu Mobile to earn an EBIT of USD 8m in 2013!!!, so if we take today’s enterprise value this implies an EV/EBIT of 21x on earnings two years in the future! To sum it up: both Gameloft and Glu Mobile are valued significantly higher than G5 Entertainment.

The fair value:
We believe a fast growing company in a fast growing sector with superior profitability and a strong balance sheet should normally be valued at a 12m forward PE-ratio of 30x and upwards. We acknowledge that G5 Entertainment is still a small company with no institutional ownership and a rather short track record. This explains in our opinion the steep discount to peers and other growth cases. However, we are convinced that this discount will disappear over time as G5 Entertainment is likely to continue to beat its own targets and more and more investors will become aware of the stock. As a first step we would expect the share to trade at a PE-ratio of 20x. Applying this on the current 2011 EPS estimate of SEK 1.90 we see a short-term fair value of SEK 38 per share. Nordic Investor holds shares in G5 Entertainment. We would not be surprised if sooner or later one of the bigger software companies will put a bid for G5 Entertainment if the low valuation continues to persist. There has been some activity on the M&A front in the app market in recent months.

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