Wedbush Begins Ubisoft Coverage, Finds Stock 'Compelling'

Wedbush Morgan's Michael Pachter has issued a research note to investors revealing that the firm has initiated coverage of Ubisoft, labeling the major publisher and developer's stock as a “compelling investment” with a “buy” rating and a 12-month target price of €34 ($44.75). Currently shares of Ubisoft are trading at €25.06 ($32.9). The analyst, which also covers other video game companies such as Activision, THQ, and Electronic Arts, also notes expectations of growth for Ubisoft of a rate of 30 percent or more over the next several years, driven primarily by the company's “key brands, its slate of promising releases, and its aggressive launch presence on the new consoles.” In addition, Wedbush also notes that Ubisoft is “well-positioned to gain market share during the next generation console cycle.” Wedbush also anticipates that the combined U.S. and European video game software markets will grow by 15 percent in the coming year and into 2008, and that Ubisoft could see its revenues grow by 25 percent annually over the same two year period. The firm bases this assumption on the number of titles released for next-generation platforms during or near the launch of the PlayStation 3 and Wii, as well as the continued strong retail performance of its Xbox 360 offerings. Currently Ubisoft has 10 titles announced for the Wii, some of which have already been released, as well as 5 for the PlayStation 3, and 7 holiday titles for the Xbox 360. Pachter further adds: “We believe that strong sales of next generation consoles over the next year will provide a positive catalyst for Ubisoft.” Wedbush also expects that Ubisoft will continue to reinvest its profits from strong software sales into its development efforts and intellectual properties going forward, while the company's established franchises such as tom Clancy, Prince of Persia, Star Trek, and Rayman “should provide solid revenues for years to come.” Pachter further notes: “We expect growth from market share expansion on the next-generation consoles as well as from the introduction of new brands such as Assassin’s Creed, Driver and Haze.” However, the analyst does point out a few risks to investors regarding the Montreuil-sous-Bois, France headquartered video game company, particularly with regards to the company’s current valuation, which Wedbush notes appears high relative to its current earnings, though the firm notes that it believes that “it is more reasonable to value Ubisoft by reference to its future earnings.” In addition, the firm also concedes that Ubisoft is highly leveraged with its significant fixed cost for development staff subjecting it to losses should it lose market share. However, the analyst balances this by noting: “We think that leverage works both ways. Because of its relatively large investment in development staff, Ubisoft is positioned similar to Electronic Arts to generate significant operating leverage from small increases in revenue. The company has only around 42 million shares, meaning that each €100 million in revenue could generate operating profits of around €0.50 per share, assuming that its operating margins are 20% on incremental revenue. We think that as Ubisoft grows, its variable operating profits will approach 40%, suggesting even greater operating leverage in FY:09 and beyond.” Wedbush further adds that some risk could also be seen in the fact that Ubisoft's stock is “relatively thinly traded,” indicating that it is only traded on the Paris stock exchange. However, Pachter further notes: “We believe that the Paris stock exchange rules provide adequate regulation, and believe that there is little risk that Ubisoft’s results would materially differ if it were listed in the U.S. We also note that most institutional investors are able to trade globally.” Pachter also compares Ubisoft to THQ from a revenue perspective, and to Activision from a product perspective. Explaining, Pachter wrote: “Ubisoft’s and THQ’s expected revenues in FY:08 are similar (approximately $1 billion for Ubisoft and $1.1 billion for THQ), but Ubisoft trades at a 20% discount to THQ’s enterprise value. As we expect Ubisoft to grow revenues at a rate higher than the industry average, while we expect THQ to grow in line with the industry average, we think that this valuation disparity will narrow over time. On the product side, we see similarities to Activision, which has a well-established lineup of owned intellectual property, and think that Ubisoft could deliver operating margins close to Activision’s historical operating margin of 13% should Ubisoft grow its revenues to the $1.4 billion level (around €1.05 billion). At this level, Ubisoft’s earnings should be well in excess of €4/share.” Looking ahead to what the future might hold for Ubisoft, particularly with regards to rumors and speculation surrounding a possible acquisition or merger, the analyst notes that while Electronic Arts currently owns a 20 percent stake in the company following a somewhat controversial purchase of shares in December 2004, Wedbush does not feel that it is appropriate for EA to make passive investments in public companies. “In our view, EA shareholders can decide individually whether an investment in Ubisoft is prudent (and of course, we think it is),” wrote Pachter. “We therefore believe that EA should either complete its acquisition of Ubisoft or divest of its minority interest. With approximately $2.4 billion in cash, EA could complete its acquisition of Ubisoft at any time.”