I recently wrote in great detail what I consider to be one of the more sure megatrends of our time, that of the continued rise, popularity, monetization, and profitability of competitive video gaming or esports.
My intent today is to survey an ETF whose holdings were chosen to capitalize on this trend, the Roundhill BITKRAFT Esports & Digital Entertainment ETF (NYSEARCA:NERD). After an overview and my personal opinion of the ETF overall, I will provide a brief description and analysis of five of the companies in the NERD ETF. My hope is that people will achieve a level of familiarity with these businesses so as to be better informed in their buy/sell decisions. This is in keeping with what many famous investors have insisted on, that people know what they buy. Knowing what is bought can be hard to do with an ETF that sometimes holds a hundred companies or more. But with NERD only having 25 holdings, it is more feasible to have a basic knowledge of these entities, thus increasing people's confidence as to whether or not the ETF really meets their personal investment criteria.
NERD is designed specifically to be a pure-play on esports. It tracks the Roundhill BITKRAFT Esports Index "which employs an objective, rules-based methodology to track the performance of a modified equal-weight portfolio of globally-listed equity securities of companies that are actively involved in the esports and other digital entertainment industries", as per the fund's prospectus. That active involvement includes companies whose line of business is: "video game publishing, video game development, video game streaming platforms, organizing video game tournaments and/or events, operating and/or owning video game leagues, owning competitive video game teams, and gaming hardware and technology companies or whose principal business activity is classified as that of another digital entertainment business activity, such as broadcasting, interactive home entertainment, interactive media & services, technology hardware storage or technology hardware, storage and peripherals." The fund is reconstituted and re-balanced quarterly.
The expense ratio currently sits at 0.25%, but will move to 0.5% in June of 2020.
First, I find a bit of conflict between how the fund labels itself and how it markets itself. Notice in the quoted description above that, in addition to esports, it targets companies that are involved in other digital entertainment business activities. It's even in the name, "esports and Digital Entertainment." As we will explore later, this apparently includes e-commerce as well as streaming content having absolutely nothing to do with esports or even video games. This in spite of the fact that the front and center banner on the NERD ETF homepage from Roundhill Investments says that they are a pure-play:
*Image from nerdetf.com
How can you be an esports pure-play if you include other forms of digital entertainment and even e-commerce? The conflict becomes more severe in context of the fact that the ETF is supposed to have the heaviest weight in pure-play companies, yet we see that often the heaviest weighted companies in the ETF have size-able business lines that have absolutely nothing to do with esports or even video games. We will explore that more below when I get into analyzing the specific companies.
Second, a quick word on the quarterly rebalancing. I have mixed feelings. If you are constantly shaving your winners off the top, it doesn't allow room to let them run and will mute gains. In a bull market, this effect will be particularly pronounced. That being said, the phrase "the bigger they are the harder they fall" has some applications for investors. Taking gains from the best performing assets and rebalancing them into the others has a decided value tilt. It will prevent the portfolio from wreckage when those top performers revert to the mean and will funnel monies into more reasonably valued securities. If I were to tweak things here, it would be to rebalance less often. History has shown that markets go up longer and stronger than they go down. It also shows that the gains are largely attributable to just a handful of companies. In context of those two factors, it makes sense to not be fiddling with portfolio balance every three months. That is too much, in my opinion. Many famous investors have said that investment portfolios are like soap: the more you handle them, the smaller they get. I believe this quarterly rebalancing is simply too much handling. They ought to let the winners run.
It is my opinion that, in the absence of time or resources to dive deep into each company's fundamentals, a few metrics are more important than others:
Revenue: Growing revenue indicates that demand is healthy for the company's products or services. If revenue growth is non-existent, eventually, the company will be too.
Return on Invested Capital: Of all the return ratios, this is my favorite. It takes into account the capital structure of the company without the vagaries and manipulation that can be present in EPS numbers from which return on assets and return on equity are based. If the ROIC is rising or at least staying stable, management is stewarding well the company's resources. Capital allocation is paramount. ROIC allows for a snapshot of how effective the capital allocation is.
Operating Margin: This is largely a function of overhead expenses. If a business can contain costs on the SG&A side while growing, it is a very good sign. I typically like to see steady or improving operating margin. This often happens when SG&A stays the same or decreases as a percentage of revenue.
Debt and Shares Outstanding: I shy away from companies that are constantly accessing capital markets. I understand that debt is sometimes necessary for ambitious growth. I understand that common stock can be used as currency to fund growth. However, if this is happening frequently and excessively, it becomes a question of whether or not the institution can ever be self-sustaining. Constantly tapping into other people's money adds a layer of complexity to the analysis that I don't want to deal with.
Insider Ownership: If insiders own a lot of the stock, they will be motivated to act in the best interest of shareholders since they are shareholders.
Given these criteria, I wanted to provide some observation about these metrics for some of the companies in NERD:
Sea Ltd. (SE):
Sea operates in three segments: Digital Entertainment, e-commerce, and digital financial services. The Digital Entertainment business has historically been their largest segment by revenue, but that gap has closed in recent years. Revenue from digital entertainment has gone from 94.9% of revenue in 2016 to 55.9% of revenue in 2018. It was 63% in the most recent quarter. Given the diversity of their operating segments, even in spite of the majority of revenue coming from digital entertainment, it is odd to find SE near the top of the ETF weighting.
Revenue growth has been absolutely dazzling, at a 59% CAGR since the first full year of reporting in 2014. But that is where the dazzle stops. Operating margin has been deteriorating, they lose more and more money every year, and growth in SG&A has outpaced growth in revenue and amounted to 114% of revenue in 2018. While that number has cooled in the TTM period at 70%, that is still crazy high. For a touch of granularity, sales and marketing expenses have been high due to aggressive promotions associated with their e-commerce business (free shipping) in order to attract customers. From the annual filing:
As we seek to monetize the user base and gradually reduce these promotions, we may adversely affect user experience and users may leave our platform. Our operating expenses may continue to increase as we invest in marketing efforts, hire additional local employees, and continue to invest in the development and expansion of our platform, including offering new content and services. These efforts may be more costly than we expect and our revenue may not increase sufficiently to offset these expenses. We may continue to take actions and make investments that do not generate optimal short-term financial results and may even result in increased operating losses in the short term with no assurance that we will eventually achieve the intended long-term benefits or profitability.
Interestingly, the Digital Entertainment segment has been doing great. They boasted 42% gross margins in 2018 and 59% adjusted EBITDA margin in the most recent quarter. Revenue grew 212% QoQ. And what of e-commerce? For 2018, the cost of servicing the e-commerce segment alone wiped out nearly all of the digital entertainment revenue. You read that correctly. The expenses associated with running their e-commerce platform almost completely eliminated all sales generated by their gaming segment in 2018. The same was true of the most recent quarter. Digital Entertainment EBITDA was $266 million. E-commerce EBITDA was negative $253.7 million. This is where the investment thesis breaks down for me. The company has never had a profitable year. Expenses are out of control. And, this in spite of a promising digital entertainment platform.
Their hit game "Free Fire" was the highest grossing game in Latin America and Southeast Asia. It was in the top five of the most downloaded mobile games in the whole world for three consecutive quarters on Google Play and the App Store. They run national qualifiers and regional leagues for their "Free Fire World Series", which had over 100 million online views. All these great stats are dragged down by a segment that has little to nothing to do with esports or gaming. So, why are the folks at Roundhill referring to it as a "pure-play" esports ETF? Even if the e-commerce segment becomes wildly profitable, any resulting share price appreciation that thereby benefits NERD will have nothing to do with the esports megatrend. This company, in my opinion, simply doesn't belong near the top of this ETF. It might not even rightfully belong in the top ten.
Shares outstanding have ballooned by 55% since their IPO, and they just filed for a $1 billion note offering. Seeking Alpha lists their insider ownership at 17%, which is very good. But it doesn't redeem the other follies, in my opinion.
How SE ended up near the top of the NERD ETF is a result of the proprietary weighted system the folks at Roundhill use. As per the prospectus:
Pursuant to the rules-based Index methodology, each quarter, during the review and reconstitution of the Index, a proprietary “thematic relevance score” (a “Company Score”) is determined by Roundhill for each company in the Index Universe. The Company Score is based on a combination of an initial score (as defined in the methodology) and a key-word search of publicly available regulatory filings, analyst reports, and industry-specific trade publications, as well as potential additional scoring if the company is included in any of the following sub-industries: broadcasting, interactive home entertainment, interactive media & services, technology hardware storage or technology hardware, storage and peripherals. Companies with a score of 125 or greater are classified as pure-play companies, companies with a score of less than 125, but greater than 75 are considered core companies, and companies with a score of less than 75, but greater than 25 are considered non-core companies. Companies with a score of less than 25 are excluded from the Index.
Furthermore, in an email exchange with the CEO of Roundhill, Will Hershey, I learned that their methodology consists of:
... screen(ing) public filings for keywords and phrases related to esports and game streaming. Couple with a few additional factors, this provides us with a score for every company in our universe. From there, each company is assigned a classification as "pure-play", "core" and "non-core". Provided that liquidity is sufficient, we then assign "pure-plays" a weight of 1.5 times the weight of "core" companies, and "core" companies 1.5 times the weight of "non-core" companies. The result is a portfolio that we believe is succeeding in our primary goal -- providing exposure to esports.
I am at odds with their approach here. Technically, I could form a company that rubs sun-tan lotion on Irish people at the beach, but if I talk about esports a bunch in my company filings, I would show up on their screen results.
According to this, Sea was assigned a "pure-play" weighting even though it is far from an esports pure-play. Sea demonstrably cannot be considered even a pure-play video game name.
I think this is ultra-relevant. I just don't think Sea has much to do with esports. They run a single tournament for a mobile game and are involved in the streaming ecosystem. But the majority of their digital entertainment revenue comes for the download of the game itself and in-game purchases. Not esports. Then, there is the whole e-commerce thing. I don't love Sea being in this ETF, and certainly not at the top.
AfreecaTV Co. Ltd.:
AfreecaTV is another enigma regarding its placement in this index. Included in the top ten of the ETF by weight, it is South Korea's version of Facebook (FB) live-stream and features a tremendous breadth of content in addition to video games. Some of this content westerners would consider rather bizarre. For example, a rather popular genre is that of "Meok Bang", or broadcasting and eating. In essence, teenagers will live-stream themselves having dinner. This type of content makes up 5% of the platform. Then, there is "Sool Bang", or broadcast drinking and "Study Bang", or broadcast studying. Some of these are so popular that the "stars" make money equivalent to a full-time job.
Their revenue model is unique. Rather than relying on advertising, when users log on, they watch for free but can gift digital currency to their favorite BJs, or broadcast jockey. That digital currency can then be exchanged for real money. AfreecaTV takes a portion of those donations. This unique model seems to me to be particularly exposed to recession risk. When people are making less money during challenging economic conditions, they might not pay to watch a stranger eat anymore. Or play video games. Or host a game show.
While esports is certainly a large part of the AfreecaTV community, to consider this a pure-play to be put towards the top is far from the truth. StarCraft is a big part of the platform, and they even have their own League of Legends team named the "Afreeca Freecs". According to 'The Korea Times',
Afreeca TV is also specialized in game streaming. The firm operates an esports stadium in southern Seoul and has held various esports competitions for games such as Blizzard Entertainment's "StarCraft," PUBG's "PlayerUnknown's Battlegrounds" and Riot Games' "League of Legends." Teaming up with local broadcaster SBS TV, Afreeca TV also established a joint venture, SBS Afreeca TV, last November for esports and sports broadcasting. It is also broadcasting the biannual esports championship "League of Legends Champions Korea" starting this 2019 spring season.
Yes, video gaming may be their bread and butter. But a pure-play?
The most popular streamer on AfreecaTV, a broadcast jockey ("BJ") known as Gamst, features some video games but seems more involved in soccer. When he broadcast the 2018 Russian World Cup 350,000 viewers tuned in.
It is vital also to note that AfreecaTV has been losing subscribers to the likes of Twitch (AMZN) and YouTube. Citing "lower hurdles for new content creators" and "more efficient communication channels with their users" as a reason for the departure, local players like AfreecaTV are trying to adapt. Their mobile TV app peaked at 1.99 million active users way back in 2016. It was down to 1.25 million in 2017.
This decline in active users and their switch to other platforms have been coincident with popular streamers similarly leaving AfreecaTV and going over to YouTube. Back in 2016, South Korea's top streamer, long at odds with the cut that AfreecaTV takes from viewer donations to him (30-40%), finally got fed up when Afreeca suspended his account when he did a corporate commercial for a mobile game without getting Afreeca permission first. According to him, Afreeca demands a huge cut of the profits from sponsored broadcasts, up to $9,000. YouTube charges him nothing.
Financially, there is a lot to like about Afreeca. Revenue growth is awesome, ROIC is in the high teens, operating margin is healthy, they have no long-term debt and stable shares outstanding. But all that is less relevant when the company is weighted as a pure play but is clearly not. That, coupled with the struggles mentioned above, makes me weary of them have such a heavyweight inclusion in the index.
Activision Blizzard (ATVI):
In my opinion, Activision Blizzard should end up heavier weighted. It is currently #4 in the index at 5.77%. They have the three of the most popular video games in history, two with plenty of esports potential.
First in the line-up is Overwatch. A team-based first-person shooter in only its fourth year, Overwatch has come to be a dominant force among video game hobbyists, professionals, and spectators. The Overwatch esports League has teams across three continents and annually hosts the Overwatch World Cup. Overwatch matches are even featured occasionally alongside traditional sports games on ESPN, and the New York Mets COO is counted among the Overwatch eSports investors.
In the 2019 opening season of the Overwatch League, it boasted considerable growth:
*Image from variety.com
As the game continues to churn out new characters, the landscape should remain fresh and vibrant.
Next is Call of Duty. News broke in September of this year that there will be a dedicated Call of Duty esports league, starting competition in 2020 with twelve teams based across the U.S and in London, Paris, and Toronto.
Call of Duty is one of the most popular video games of all time. Its many versions have won the top seller spot in the years 2009, 2010, 2011, 2012, 2014, 2015, 2016, and 2017. Its most recent iteration, released on Oct. 25, is on track to be the best seller this year too.
Finally, we have Candy Crush. While not really an esports phenomenon and, therefore, slightly outside the scope of my intent, it is worth mentioning that Candy Crush is the most popular game on Android, edging out the likes of Angry Birds and Pokemon Go. The game has been downloaded several billion times.
It is also worth mentioned that ATVI is busy in the mobile esports space too. Call of Duty Mobile has several rounds of tournaments slotted on mobilesports.org.
In terms of financials, ATVI has been a pretty consistent business. They have grown revenue at 10% annually over the past 5 years, and their operating margin has been in the high 20s since 2011 with the exception of bad drops in 2016 and 2017. Shares outstanding have swelled a bit since 2014, from 726 million to 770 million due to stock option grants. The announced a share buyback program in January of this year, but it should be noted that they did the same in 2017 and did nothing with it. Frankly, though, that was a prudent move as the stock did nothing but go up in that period. Likely, management estimated that the stock price wasn't undervalued, and therefore, repurchases would not have been a good use of cash. With ATVI currently sitting under its 5-year valuation averages, perhaps we can expect some buyback activity.
ROIC has been going up over time, from ~8 in 2014 to 11.5 today. Today, ROIC is the second highest it has ever been, shadowed only by last year's 13 read.
Debt is headed in the right direction. They have more cash than they have long-term debt. I am not much concerned here.
Their cash conversion cycle is great. It has hovered around ten days since 2012.
Finally, insider ownership has stayed around 1.31% for years. I view this being slightly low, but ATVI does maintain provisions where the executive directors must own a meaningful amount of shares (10X base annual salary for the CEO and equal to annual salary for others).
NetEase Inc. (NTES):
NetEase is a conglomerate that has diverse product and service lines to include cloud music, online education, e-commerce, and email. However, their online gaming segment is by far the biggest. It comprises nearly 80% of their revenues. However, of that 80%, about 70% comes from mobile games. The remainder comes from PC games. NetEase has tons of titles but is popular mostly in Asia, particularly, Japan. To be truthful, I haven't heard of a single video game owned by NetEase. Perhaps you have: Knives Out, LifeAfter, Identity V, Rules of Survival, Crusaders of Light, Cyber Hunter.... the list is very, very long.
Their financials are impressive. Revenue has grown by a whopping 43% CAGR over the past 5 years. They boast some of the highest operating margins in the space history, though things have dipped a lot in recent years and currently sit at about 14% down from 47% back in 2013. Shares outstanding have remained the same, and they have no long-term debt. ROIC is higher than the names we have covered thus far, though it too has slid in the past couple years. Currently at 13%, it was as high as 30% in 2016. Inside ownership here is crazy high: 45%.
The financials are glowing in spite of recent woes. The most compelling part about NetEase is the recent surge in esport activity in the mobile space. According to Will Hershey, CEO at Roundhill, this is the space he is most excited about:
Mobile esports, and mobile gaming more broadly, is the fastest-growing segment of the market -- and for me personally, it's arguably the most exciting trend in the space. As a result of advances in smartphone technology, we are finally at the point where gamers can enjoy immersive, advanced gameplay on their phones. While this may be less relevant in developed gaming markets (i.e. US, Japan), it is critical in emerging markets. In regions like Southeast Asia and Latin America, console penetration rates are very low. Many people can't afford a $500 console or $2,000 gaming PC. As a result, they are gaming on their phones, and mobile esports have taken off in these markets.
In terms of esports, successful mobile titles include Arena of Valor (Tencent), Garena Free Fire, and PUBG Mobile. In the case of Free Fire, Sea's self-developed battle royale, the viewership metrics are competing with PC esports. On their last earnings call, the company highlighted that the Free Fire World Series 2019 achieved 100 million cumulative online views to date, including 1 million concurrent viewers for the Brazilian qualifiers. Free Fire has generated over $1 billion in revenues to date.
In October of this year, Tencent, Activision and Sea teamed up to launch Call of Duty: Mobile. The game has been very successful, hitting 172 million downloads and $87 million in revenues in its first two months. This represented a meaningful milestone for mobile, in which an AAA developer was able to successfully port existing IP to mobile. I expect this to continue, with Apex Legends reportedly launching on mobile next year.
All this considered, NetEase has a place in the portfolio of people banking on the growth of mobile games and the role they will play in the larger esports landscape.
Electronic Arts (EA):
EA has its own impressive list of well-known and popular titles, particularly dominating the traditional sports video game sub-genre with FIFA and Madden. FIFA, in particular, has risen to a predominant place in the esports world. The FIFA eWorld Cup is held annually, and the total prize pot for this year amounted to $500,000. The event was broadcast across the world in six different languages to 75 different territories. Viewership increased 60% from 29 million in 2018 to 47 million in 2019. FIFA is their most popular title, and revenues associated with FIFA are dominant.
Other important games they own include Battlefield, Anthem, the Sims, various Star Wars titles, Plants vs. Zombies, and Need for Speed. None of these are ranked in the top ten of esports involvement, but are nonetheless popular. Many of those titles have several iterations.
As for our key metrics, revenue hasn't seen tremendous growth. Since 2010, they have only grown sales by 3.43%. That being said, they have managed to improve margins from ultra-low/negative in the 2010-2014 period to staying in the 20s since 2015. ROIC descended steadily from 2015 through 2018, going from 26% down to 16%. However, over the TTM period, it's at 38%. A share buyback program has reduced shares outstanding by 9% since 2015, and they have only accessed capital markets for long-term debt once in recent history, back in 2016. Their debt load is very manageable, with debt/equity at 0.14% and interest covered 27 times. Insider ownership is at 2.18%, which is okay.
Overall, I like EA as a reliable play. Soccer is one of the stickiest sports in the world in terms of fandom. The electronic equivalent in Fifa is sure to be a stable source of revenue for EA for many years to come.
Overall, I think NERD has some good things going for it. I think it is far from perfect, but suitable for those not wanting to hold several individual names. I take particular issue with their "objective, propriety, rule based modified equal weighting" program that stacks the ETF. It seems based on strange premises (how many times a keyword pops up in company filings), and running that rule-based system every quarter to rebalance things seems like an excessive amount of buying and selling.
In my opinion, the content creators belong at the top of the weighting scheme, all the time. Some of those names we discussed today, along with others: Activision, EA, Tencent (OTCPK:TCEHY), Capcom (OTCPK:CCOEY), etc. They own the IP and stand to benefit most in the long run from the continued growth of video games and esports. Especially, as these content creators create leagues, monetization will follow. As is often said, content is king.
Today, I talked about five of the companies that routinely land in the top ten of NERD by weight. I plan in the near future to publish further articles that discuss more of the businesses until all 25 are perused. Again, I am doing this so that potential buyers can know what they are buying and the strengths and weaknesses of the companies involved. It is not enough to buy an ETF that appears to be involved in a space that is lucrative and attractive. Obtaining wide exposure to an industry or sector by buying an ETF does not guarantee good returns. Often, ETFs unfortunately and oddly have some peculiar inclusions in them, and knowing those things can sway the investment thesis. For NERD, in particular, I don't love that it has several companies who have business lines that have nothing to do with video games or esports. Especially considering the fact that those other business lines are dragging down the profitability of the company as a whole. Nonetheless, I find NERD suitable for those trying to ride the esports wave.
This article was written by
Disclosure: I am/we are long NERD, ATVI, TCEHY. 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.