• Thu. Sep 21st, 2023

Embracer: gaming ‘roll-up’ battles claims of aggressive accounting

The Swedish founder of the biggest gaming company in Europe sits overlooking a frozen lake from his snow-clad holiday home in Karlstad, where he courted more than 70 business and media professionals before buying many of their companies.

As the chef from his private jet cooks a three-course meal in the kitchen next door, 45-year-old Lars Wingefors insists that Embracer does not fit the classic playbook of a “roll-up”, in which a company aggressively buys up lots of smaller entities. “There are bad stories out there, but we need to prove that we are different,” he tells the Financial Times.

Wingefors has transformed the once obscure Swedish developer into a sprawling games empire with a market capitalisation of SKr58.7bn ($5.64bn).

But his light-touch approach to integrating newly bought businesses, along with the gulf between Embracer’s actual and adjusted profits, have generated fierce criticism from a number of hedge funds and investors. These concerns are thwarting his efforts to cultivate a strong shareholder base outside of Sweden.

At the heart of the debate lies a simple question that becomes hard to answer when more than 100 distinct businesses are funnelled into one set of financial statements: do the profits from selling a game justify the cash invested in developing it?

Embracer achieved its size through a four-year acquisition spree, gaining interests in multiple studios, the US comics publisher behind Hellboy and Sin City, intellectual property for The Lord of the Rings, and board games such as Catan.

Sales have increased almost hundredfold, from SKr178mn ($17mn) in 2014 to SKr17bn ($1.64bn) last year, helping Embracer build an enthusiastic local shareholder base.

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The company’s frantic dealmaking also attracted sceptics wary that, like so many roll-ups before it, the result will prove to be a fractured mess worth far less than the sum of its parts.

Four hedge funds with short positions in the group outlined concerns to the FT. 

Among the issues they raised are: the difficulty in assessing the company’s financial performance due to repeated internal reorganisations and a switch from local to international accounting standards; accounting practices around newly purchased companies that may obscure the group’s underlying performance; and a belief that the company is poorly positioned for a wider downturn in the gaming sector after a coronavirus pandemic-fuelled boom.

“They’ve been acquiring all these companies, so you can’t get to their organic growth at any time,” said an investment manager at a British hedge fund that holds a short position. “The reality is that when the music stops, they’ll start to struggle to pay down debt.”

Other investors and analysts argue that critics have a misplaced reverence for organic sales growth and overlook the logic of industrial consolidation. “Fundamentally [the critics] are a bunch of finance guys that don’t understand it,” said Thomas Singlehurst, an analyst at Citi who is bullish on Embracer.

The board game ‘Settlers of Catan’
The board game ‘Catan’ is one of Embracer’s many properties © Britta Pedersen/picture-alliance/dpa/AP

Singlehurst points to recent deals Embracer made to distribute its IP, including a licensing agreement signed last month with New Line Cinema and Warner Bros Pictures to make a series of feature films based on Lord of the Rings.

Wingefors has “created a big hat”, he said, “that doesn’t necessarily mean he can pull a rabbit out of it but there are a lot in there”.

Embracing diversity

Wingefors’ dinner table pitch to entrepreneurs is a supportive home that leaves them free to pursue a creative vision, with no forced cost cuts or centralisation. He boasts that of 108 business owners that have entered the group, 106 remain. “If it’s not broken, why should you start messing around with people?” said Wingefors.

The strategy, he said, is diversification and cross-pollination. Embracer’s 134 studios should produce a steady stream of blockbuster computer games, while reducing the risk attached with development at any individual house. Popular intellectual property will then be transplanted into console, mobile and tabletop games.

“Lars is almost religious about this idea of no forced synergies between the groups,” said Randy Pitchford, chief executive of US video game developer Gearbox, purchased by Embracer in 2021.

By contrast, gaming groups typically seek opportunities for cost-cutting in their dealmaking. When Take-Two acquired mobile specialist Zynga last year for $12.7bn it touted $100mn in “synergies”.

For all the focus on executive freedom and diversification, Embracer lost money over the past seven quarters, a cumulative operating loss of SKr838mn ($81mn). 

Like many tech companies, it directs investors to ignore some costs as temporary. Johan Ekström, Embracer’s chief financial officer, said it “definitely makes sense” to exclude acquisition-related costs from adjusted earnings before interest and tax — Embracer’s preferred metric to judge profitability — because they have “nothing to do with the underlying performance of the company”. 

Column chart of Embracer's operating and adjusted ebit figures for last 7 quarters, SKr (bn) showing Embracer's adjusted profits soar above operating profits

Those adjustments turned a seven-quarter loss into operating profit of SKr9.9bn ($950mn). 

What is striking about the adjusted figures is how Wingefors asks investors to ignore the expense of paying the executives he so carefully wooed at his lakeside chalet.

Costs investors are told to ignore are predominantly “earn-outs” paid to acquired business owners — either in cash or shares — if they remain in post for a certain duration, or if they reach business milestones and financial targets.

Neil Campling, co-founder of Chameleon Global, which has no position in Embracer, said the company stood out for the quantity of acquisitions and the scale of adjustments that are “huge relative to deal size”. He added that it was unusual to see tech companies make large adjustments to profits for earn-outs.

Column chart of Total cash 'earnout' obligations, SEK (bn) showing Embracer's calculation of cash 'earnout' obligations have risen between quarters

In total, Embracer estimates the present value of “obligations related to historical business combinations to be settled in cash” is SKr11.2bn. Of that, SKr7bn is recognised as a liability on the balance sheet as “contingent consideration” — amounts paid to the former owners of acquired companies if they achieve certain milestones — with SKr4.2bn representing future personnel costs to be recognised when incurred.

The company said it follows international accounting standards, having moved to the IFRS regime last year, provides adjusted profit metrics “to further increase the understanding of our business” and had “a solid balance sheet”. It added that personnel costs paid “to a handful of selling shareholders in addition to the market-based salary they earn should not be viewed as a long-term reasonable reimbursement”.

Column chart of Items as a % of change between ebit and adjusted ebit, Q1 to Q3 2022 showing Earnouts make up lion's share of Embracer's profit adjustments

Timing is everything

Embracer’s hands-off approach means the business model of a games studio is the same once it joins the group, but accounting for a takeover involves subtle choices that can flatter profits in the short term.

For instance, Embracer has invested SKr7.7bn in games development over the past seven quarters. Once a game is released, the related costs are then amortised through the income statement to cleanly set them against their associated sales. Like US peer Activision Blizzard, Embracer amortises software development over two years.

Acquisitions can muddy the picture. Shadowfall, the investment firm run by Wirecard short seller Matt Earl, highlighted in a report to clients that for Embracer’s purchase of a collection of businesses in 2021 for SKr5.3bn, almost all of the purchase price was added to the balance sheet as goodwill, which is not amortised. Embracer allocated just SKr27mn to ongoing or finished game development, “which is considerably lower than what would be expected for companies of this size”.

To Shadowfall and other short sellers, Embracer’s complexity, reorganisation and shifting accounting represent cracks in the foundations of a business that signal trouble ahead.

Sceptics also argue that Embracer paid top prices for middling-quality studios at a moment of peak pandemic demand; its mobile and PC divisions both shrank on an organic basis during the most recent quarter, the crucial Christmas trading period.

Embracer said that of the 11 acquisitions it announced in August 2021, 70 per cent of the value was for two acquisitions. It said the first, Crazy Labs, makes advertising-based mobile games where development cost is not capitalised. Of the second, Ghost Ship Games, it said the company’s popular game Deep Rock Galactic was already published by an Embracer studio at the time of purchase, so capitalised development costs were already reflected on the group’s balance sheet.

Change of tune

Embracer adopted a more subdued tone in November 2022, announcing a review of its business, a much higher bar for acquisitions and that it would consider spinning off some units.

Wingefors told the FT he would “love” to continue making “big move” acquisitions but it is “not the right time” given limited shareholder appetite.

The entrepreneur underlined his ambition to attract more international investors. “There is scepticism, and I understand that,” he said, but lamented that many are “not willing to invest the time to understand the business”.

Two of Embracer’s founding investors ⁠ — Erik Stenberg and Pelle Lundborg⁠ — slashed their holdings of Class B shares over the past year. Stenberg halved his holding after he stepped down as deputy chief executive, while Lundborg reduced his by 33 per cent.

Lundborg did not respond to a request for comment. Stenberg cited “personal finance reasons” for cutting his stake and said his “belief in the future of Embracer is unchanged”.

Avanza, a Swedish asset manager that offers services to domestic retail investors, remains a top-20 holder of Embracer stock, reflecting its continued allure to locals.

At the checkout of a supermarket in Karlstad, a young cashier says he does not have much knowledge of the stock market, but he knows Wingefors and he owns Embracer shares. “It’s a good company, everyone knows it here. More and more people around the world are gaming, so I believe it will grow.”

This article has been amend to make clear Lars Wingefors bought many of the companies whose representatives he entertained at his holiday home


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