Paradox Interactive (OTC:PRXXF) is an excellent game developer and publisher. For lovers of the grand strategy genre, it has some of the most iconic franchises. For investors, it has also been a rewarding enterprise. While the company is expanding and going strong, the valuation is rather rich. Keep it on your radar and wait for a pullback to buy some, but at current prices, it’s a Hold.
Before looking deeper into the business, let’s see how Morningstar sums up the company:
Paradox Interactive AB is a Swedish company. It is engaged in the development and publishing of PC-based strategy games. The company’s product portfolio includes franchise brands such as Stellaris, Europa Universalis, Hearts of Iron, Crusader Kings, Cities, Skylines, Tyranny and Magicka. Paradox is also involved in publishing and internal development of games and licensing of White Wolf’s brands. The company distributes its games through digital platform Steam as well as on Apple, Google Play, and Sony store. It operates its business across the world. The majority of the company’s revenue comes from the United States.
For those who haven’t played any of the Paradox games, it might be good to expand a bit on that first. Most of the titles produced by the company fall within the grand strategy genre. Think of a board game such as Risk or Axis & Allies, but greatly expand on that and give it far more options. This gives the games lots of playing time and replay value. Add to this that Paradox is really involved with its community and regularly adds features and expansions based on their feedback. It has even bought community sites that help explain its games. All these expansions come at a price, of course, so Paradox can extensively monetize one game. The company is also offering a subscription model so it gets recurring revenues. Via licensing, organic growth and acquisitions of other studios, Paradox is expanding its gaming portfolio and growing the business. Currently, the company operates nine studios:
The expanse is clear over the last few years, and given that the game industry is set to grow, Paradox will likely see further growth. Something to take note of is the fact that gaming giant Tencent (OTCPK:TCEHY) has a five percent stake in the company.
Paradox Interactive went public in 2016 and has been on tear ever since. It started trading at 46 SEK at the end of May 2016, and at the time of writing, the share price stands at about 300 SEK. So, those are great results.
Something to consider is the fact that Paradox has its primary listings in Stockholm, Sweden. For investors looking for more liquidity or with a preference for trading in SEK, this might be a better option than the tickers mentioned at the start of this article.
First, let’s see what the company’s income statements tell us:
(Source: Seeking Alpha)
Normally, I’d look at a data set going back a decade, but with a shorter track record, less must do. The global picture on the income statements is, however, rather clear. This Nordic business is growing fast. Revenues were $22.6 million in 2014 and have since greatly increased to $164.1 million TTM. Operating income has seen an even larger gain TTM, at $65.1 million starting from $7.5 in 2014. With net income currently being over twelve-fold its number six years ago, the growth is simply staggering. Paradox still isn’t a major player in the industry, but if it can keep expanding like this, it won’t take very long.
(Source: Seeking Alpha)
Not only has the income statement grown bigger, but the balance sheet is about eleven times larger than it was at the start of the shown period. Even better still, it hasn’t been debt that fuelled the expanse; Paradox has zero debt and net cash of $45.5 million. This is after a deduction for capital leases. Without accounting for this item, cash stands $19 million higher. The strength of the balance sheet is excellent. A classic sign of this is the fact that current assets are higher than the total amount of liabilities. Typical red flags, such as pension liabilities, for example, aren’t to be found, and for a software company, intangibles make up a relatively small amount of the asset base. Something to consider is that Paradox is keeping its number of shares outstanding rather flat. Given that the growth percentage is still so high, it seems a logical choice to invest in the business and not in buybacks.
(Source: Seeking Alpha)
If net income is good, then cash from operations is even better. Every year, the company’s cash from operations figures massively top the net income numbers. Better still is the fact that there is hardly any need for capex. For example, $92.8 million cash from operations was produced, but only $3.2 million was used on capex. That’s under 3.5%. I do feel like I might be repeating myself, but again, the growth displayed here is staggering. That $92.8 million was just $8.3 million at the end of 2014. The main use of that cash over the year has been the purchase of intangible assets. In Paradox’s case, that mostly means IP such as gaming titles. There have also been some acquisitions of studios, as could already be seen at the start of this piece. The results do show that this strategy is working. The company also pays a dividend, but is economical with increasing it. It does, however, add more cash each year to the balance sheet. In my opinion, that cash can be seen as a war chest for further content purchases or M&A. The great thing is that this cash balance is increasing rapidly.
So far, I’ve been only positive about Paradox Interactive. I really like its products and the company is in perfect shape. The only thing that I don’t like, unfortunately, are the multiples at which it trades. Let’s take a look:
(Source: Seeking Alpha)
It trades at about ~63 times trailing earnings, or ~35 times cash flow. Those are some steep numbers. The multiples are, however, lower than the five-year averages. In comparison, some might call them currently “cheap,” but the five-year averages are bonkers, in my book. If we set Paradox against its peer group, things don’t look that great for the valuation. The peer group consist of Ubisoft (OTCPK:UBSFF), Electronic Arts (EA), Take-Two (TTWO), Activision Blizzard (ATVI) and Embracer Group (OTCPK:THQQF). Paradox is simply more expensive than its peers. It does grow faster than most, but for me the difference is too much. Even if the peer group is extended with fast-growing Chinese players such as Tencent and NetEase (NTES), Paradox still commands the highest multiple.
It may be obvious, but the biggest risk at the moment is the high valuation. From my perspective, it is making an investment in Paradox at risk of a sudden shock. For example, if growth fades quickly or if market sentiment dims. For Paradox to start trading at the multiple its peers trade would mean a serious hit.
Another potential risk comes from the fact that Paradox has a great reliance on third-party vendors such as Steam. A conflict in this area could seriously harm sales. These days, such events are not uncommon. Just think of the clash between Apple (AAPL) and Epic Games. The truth is that vendors such as Steam, Epic Games Store and Google Play Store (GOOG) are becoming more and more important for software distribution, and they have plenty of bargaining power.
A third risk to highlight is human capital risk. Human capital is important for all businesses, but arguably even more so for creative businesses such as in the gaming industry. If a cluster of employees leaves to set up shop themselves, these holes aren’t easily filled. Within the gaming industry, there are plenty of examples where this happened. This makes acquisitions also very hard, and it is a reason why stock options are frequently used. Retaining talent is an absolute must.
Paradox Interactive is a well-run Nordic game developer and distributor. The company grows fast and is in perfect shape. As a leader when it comes to grand strategy games, it knows how to monetize its IP. The balance sheet can easily support more expansion in the years to come, just like it has been doing. There isn’t much to dislike, except for the valuation. The shares are trading too rich, so there isn’t a margin of safety. Keep this one on your watchlist for a pullback, because you’d likely want it in your portfolio. But for now, Paradox Interactive is a Hold.
Disclosure: I am/we are long EA, NTES, TCEHY, GOOG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.