Square Enix Holdings: Earnings Set To Disappoint, Low Visibility Into FY3/2025 (SQNNY)

Investment thesis

Square Enix (OTCPK:SQNNY) has disappointed with its latest sequel software release of its ‘Final Fantasy’ franchise, and we believe the company will lower its FY3/2024 guidance. Consensus forecasts look too positive for FY3/2025 in our view, and we reiterate our sell rating.

Quick primer

Square Enix Holdings is a Japanese digital content company, formed via the merger of game developer Square and publisher Enix in 2003. The key in-house software franchises include “Final Fantasy”, “Dragon Quest” and “Hitman”. The company has conducted bolt-on acquisitions to grow its title library, including Eidos for “Tomb Raider” and Taito for “Space Invaders”.

Key financials with consensus forecasts

Sales split by segment – Q1 FY3/2024

Segmental profit – Q1 FY3/2024

Updating our view after the release of ‘Final Fantasy XVI’

Our initial Sell rating was in June 2021, where we highlighted limited growth prospects post-lockdown. On June 22nd, 2023, the company released its long-awaited title ‘Final Fantasy XVI’ on the PlayStation 5. Although initial reviews appeared positive, Q1 FY3/2024 results highlighted that despite total sales growing 14% YoY driven by the title, operating profits visibly declined by 79% YoY due to the heavy amortization of development costs. Management went on record to say that the title had missed expectations.

With a very tough competitive environment in the mobile game app market as highlighted by domestic peers such as CyberAgent (OTCPK:CYAGF), we want to assess whether the company can meet unchanged FY3/2024 guidance; sales of JPY360 billion, and operating profit of JPY55 billion.

Unboxing Q1 FY3/2024 results

The company’s Q1 FY3/2024 results were a negative surprise. Despite the release of ‘Final Fantasy XVI’, the key issue was the steep decline in operating profit YoY. The way the company accounts for game development can be problematic, as it capitalizes certain parts of this expenditure which can result in low profitability on release with limited sales volume generation. ‘Final Fantasy XVI’ demonstrates this predicament with reported sales unit volumes of only 3 million units, versus its predecessor ‘Final Fantasy XV’ which shipped 5 million copies on day one. Comparisons between these two titles need to be gauged in terms of the addressable user base – ‘XVI’ is for PS5 only, whilst ‘XV’ was for PS4 and Xbox One. The company places the blame partly on the limited installed base of the PS5, but it is the software that drives hardware demand and this has not occurred – the game is simply not a blockbuster hit.

Other red flags in Q1 FY3/2024 results were sales declines in both MMO (massively multiplayer online) games as well as smart devices/PC browser games which are seen as sources of recurring income. Existing titles are beginning to lose popularity; we believe this is a combination of continued user attrition in a post-lockdown environment, as well as consumers feeling the pinch through inflating costs and cutting back on gaming spend – an unusual occurrence for a market sub-sector that has been viewed as ‘recession-proof’.

There has been limited disclosure of the performance of ‘Final Fantasy XVI’ with no updated sales volume figures. This leads us to believe that performance has remained lackluster, with no major improvement in earnings visibility into Q2 FY3/2024. As a benchmark, ‘Final Fantasy XV’ reached 6 million units of shipment in under 2 months post-release.

Outlook with the release of ‘Infinity Strash Dragon Quest’ in September 2023

One positive event to look out for in Q2 FY3/2024 is the software release from Square Enix’s most successful franchise – Dragon Quest. The title is called ‘INFINITY STRASH: DRAGON QUEST The Adventure of Dai’, it will be released on multiple platforms (PS5, PS4, Switch, PC via Steam and Windows Store, and Xbox X|S) in September 2023, and is expected to perform strongly and reliably. Development costs will be lower than ‘Final Fantasy’ counterparts with its graphics, but with limited global appeal, this release is a surefire domestic hit as opposed to a global blockbuster. Consequently, we do not think that this title has enough firepower to offset the earnings shortfall coming from ‘Final Fantasy XVI’.

The company will be showcasing key releases at the Tokyo Game Show this month, which also includes ‘Dragon Quest Monsters: The Dark Prince’ on the Switch due for release on December 1st, 2023. This is a sequel title of a spin-off series of Dragon Quest which is a capable franchise but again not a global seller.

The company has maintained FY3/2024 guidance, but we believe there is downside risk – consensus forecasts are also below guidance for FY operating profit. Looking back at FY3/2023 results the company highlighted new growth initiatives such as earnings potential from NFTs and investments in the Web3 arena which appear too nascent for meaningful earnings in the short to medium term.

As things currently stand, we believe Square Enix will also face a difficult FY3/2025 with all major franchise sequel titles being released in the previous year. With a limited release slate (‘FINAL FANTASY VII REBIRTH’ and ‘FINAL FANTASY XIV: Dawntrail’ are currently disclosed as major releases), consensus forecasts indicating flat sales YoY and increasing operating profit of 12.8% YoY look too optimistic in our view.

Valuation

On consensus forecasts, the shares are trading on PER FY3/2025 16.1x on low teens earnings growth YoY. Given the slow start to FY3/2024, we believe these forecasts are on an unrealistically positive trajectory.

Catalysts & Risks

A potential catalyst of downside comes from a delay in the release of ‘FINAL FANTASY VII REBIRTH’ which is currently expected in early 2024. The continued decline in MMO and smart device/PC browser gaming activity and falling monetization will be problematic given its high profitability.

As for upside risks, the release of ‘Final Fantasy XVI’ on the PC is in development, and with a larger potential installed base a successful release in H1 FY3/2025 could provide a boost to earnings YoY. Strong repeat sales of ‘Dragon Quest’ titles into FY3/2025 would help secure high profitability YoY.

Conclusion

We believe that the company will experience weak trading in Q2 FY3/2024 and will issue a downward revision for FY3/2024 guidance. Whilst this may be partly priced in, our concerns from our previous piece remain unchanged – the company is currently not capable of maintaining a growth profile given the waning popularity of ‘Final Fantasy’ and no new successful franchise developments. With consensus forecasts looking too positive, we reiterate our Sell rating.

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.