Frontier Developments (FDEV): Capitalised costs and amortisation

I have written an article about Frontier Developments for SharePad, and I highlighted the company’s somewhat questionable accounting:

https://knowledge.sharescope.co.uk/2020/06/10/screening-for-my-next-long-term-winner-frontier-developments/

I thought I would add some further comments here.

The accounting issue relates to the capitalisation of development costs. Companies are permitted to capitalise certain costs onto the balance sheet and avoid expensing them immediately to earnings. Those capitalised costs are subsequently expensed against earnings through an amortisation charge, which typically spreads the cost over several years.

With Frontier, I maintain that its amortisation period is too long and as such flatters near-term earnings. Sales of computer games are generated mostly within the first few months after launch, and so the associated development costs should be expensed in a similar manner.

Let’s compare Frontier to two other games developers, Team 17 and Codemasters .

The capitalisation policy for Frontier:

Development costs are amortised on a straight-line basis generally over 3-5 years, but could be over 6 or 8 or maybe 10.

Contrast that policy with Team 17:

Development costs are amortised over two years on an 85% reducing-balance basis. So 85% of the costs are expensed in year 1, then the rest is expensed in year 2. Note the text: “ The amortisation is also heavily weighted towards the first year to reflect the sales curve of titles”.

Contrast now with Codemasters:

Development costs are amortised over one year, with 65% expensed in month 1 and the rest expensed over months 2-12. Note the text: “ The directors consider that it is appropriate for the amortisation period to be based upon the expected revenue profile .”

Let’s now look at the accounting effect of these policies for the three shares.

First, Frontier:

For the last two years, total cash development costs came to £26.0m while the associated amortisation charge was £13.3m. Amortisation therefore reflected 51% of the cash costs.

Next, Team 17:

For the last two years, total cash development costs came to £7.1m while the associated amortisation charge was £7.4m. Amortisation therefore reflected 104% of the cash costs.

Finally, Codemasters:

For the last two years, total cash development costs came to £46.7m while the associated amortisation charge was £44.7m. Amortisation therefore reflected 96% of the cash costs.

The amortisation policies of Team 17 and Codemasters appear far more prudent to me, and results in development costs being largely matched by the associated amortisation charge — and therefore earnings not becoming too distorted.

The amortisation policy applied by Frontier results in only half of the development costs being expensed to earnings for a particular year, thereby exaggerating near-term earnings.

So… what makes Frontier’s games so different that the development costs can be amortised over several years on a straight-line basis…

…when other companies amortise over no more than two years, with most of the cost recognised earlier rather than later?

From this three-company sample, I have to question Frontier’s amortisation policy and its reported earnings.

Maynard

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We can extract the reported base game unit sales from Frontier’s annual reports to get an idea of their sales profiles. Elite Dangerous (launched Dec 2014) and Planet Coaster (launched Nov 2016) have the most data available. Here’s the reported unit sales (in millions) for Elite going back to 2015:

Date Base Game Units Horizons Units Franchise Units Base Game Annual Sales Rate Base Game % of Total Sales
31/08/2015 0.83 0.00 0.83 1.10 32
31/08/2016 1.60* 0.20 1.80 0.78 22
31/08/2017 2.23* 0.52 2.75 0.63 18
30/11/2018 3.00 1.30 4.30 0.62 18
30/04/2020 3.50 1.50 5.00* 0.35 10

* Up until 2018, Frontier only reported sales of ‘franchise units’ for Elite Dangerous where the base game and the Horizons expansion pack season pass (launched 2016) were both counted as a unit. From 2018 onwards Frontier only reported sales figures for base game units. At the time of the reporting change (FY19 interims) Frontier reported the total sales for both the base game and Horizon units, showing the sales mix to be 70% base game, 30% Horizons. Starred figures in the table have been derived by assuming a gradual increase in the fraction of ‘Horizons’ sales up to the 30% reported for 2018.

From these figures it looks like the base game sales profile for Elite Dangerous is actually fairly long - it is still selling around 10% of total sales per year in its sixth year of release. Here’s the charts:

Elite Dangerous Total Sales (millions)

Elite Dangerous Annualised Sales % of Total

Here’s the equivalent numbers for Planet Coaster:

Date Total Sales Annual Sales Rate % Total Sales
31/12/2017 1.4 1.29 0.48
31/01/2019 2 0.55 0.21
31/12/2019 2.43* 0.47* 0.17
31/05/2020 2.5 0.38 0.14

* Estimated

The sales profile looks like it will be shorter than Elite’s with a steeper initial decline but is still reasonably long with Planet Coaster selling about 14% of total sales in its 4th year of release. Here are the charts:

Planet Coaster Total Sales (Millions)

Planet Coaster Annualised Sales % of Total

Frontier’s latest game “Planet Zoo” appears similar in concept to Planet Coaster. The FY20 report says there will be a “48-month amortisation of the development cost of Planet Zoo” which doesn’t seem unreasonable to me given the sales profile for Planet Coaster above.

My conclusion is that Frontier’s games do appear to have longer sales profiles than those of Team17 or Codemasters. Why might that be? I think a big factor could be that Frontier specialises in building open-ended immersive worlds that are designed to be expandable and are played over longer time scales (months or years). These features give the games a certain stickiness - existing players are likely to still be immersed in the base game long after the initial release allowing the company to generate revenue over longer time frames from in-game purchases and from the inevitable expansion packs which in turn generate additional base game sales as noted in this snippet from the annual report:

paid content both helps monetise the game and brings new players as new content triggers online coverage on platforms like YouTube or Twitch, increasing sales of the corresponding base game and for other paid expansion content.

It will be interesting to see how Frontier handle the amortisation of their upcoming Formula 1 franchise which could be a different proposition - essentially the same single base game released annually but with configuration changes for different drivers, different teams, different circuits.

Hi MIA1,

Many thanks for joining the forum and posting the informative reply.

Agreed, FDEV’s games do have extended shelf lives. But the base-sale figures for Elite Dangerous and Planet Coaster still follow the same general trend of all computer games – the bulk of the sales occur just after release and are followed by smaller annual sales thereafter.

So if we are to broadly match costs with sales, the bulk of the development expenditure ought to be taken early on during the game’s life. Such policies have been adopted by TM17 and CDM, but FDEV chooses to amortise its expenditure evenly over 3-5 years, or longer. FDEV’s amortisation policy does not match the sales reality of its games.

FDEV’s 2020 presentation provides an informative chart that shows the ‘cumulative monthly cash contribution’ from three of the games. I assume ‘cash contribution’ is the cash generated by the game less associated expenses.

I have annotated the chart for the Planet Coaster and Jurassic World games:

For both games we can see the cumulative cash generated during the initial 2-month launch period represents a sizeable proportion of the cumulative cash generated thereafter. Again, this emphasises how computer-game income is biased heavily towards the early months of the game’s life.

And again, if we are to broadly match costs with sales (as per TM17 and CDM), then the bulk of the development expenditure ought to be amortised early on during the game’s life.

I suspect the amortisation policy will be similar, as FDEV could argue the underlying game development will be used throughout the four-year agreement. The annual configuration changes etc could be expensed as incurred.

I will be more interested to discover the sales profile of the game. I guess the bulk of the sales will be earned through the 2022 launch edition rather than the 2023, 2024 and 2025 versions. Applying FDEV’s current amortisation policy would suggest income from the F1 game will be spread evenly throughout the licence term, which I find hard to imagine.

Maynard

Hi Maynard

Thanks for your reply.

Yes, while the extended sales profiles of their games can reasonably account for the longer amortisation periods used by Frontier, the shapes of those profiles cannot justify the straight line amortisation policy that they have adopted.

It’s fairly easy to picture the effect that the straight line amortisation of costs has on reported profits for each individual game - near term profits will be overstated and later profits will be understated. I was wondering though if that effect is neutralised by the phasing of new game releases particularly once Frontier achieves a release rate of at least one game per year, since at that point the overall reported earnings would contain a mix of both overstated earnings for early stage games and understated earnings for later stage games.

I thought I’d do a quick exercise using the Planet Coaster sales profile that I showed in my previous post. If we assume that this profile represents the correct amortisation of the capitalised costs of development over a game’s 4 year lifespan, and apply a fixed percentage markup on those costs each year to represent revenue we’ll get a consistent profit margin each year that matches the total margin generated over the game’s lifespan (37.5% in my example):

Y1 Y2 Y3 Y4
Revenue 76.8 33.6 27.2 22.4
Capitalised Costs 48 21 17 14
Profit 28.8 12.6 10.2 8.4
Margin 37.50% 37.50% 37.50% 37.50%

Now the same table with straight line amortisation of costs and we can see the near term exaggeration of profits:

Y1 Y2 Y3 Y4
Revenue 76.8 33.6 27.2 22.4
Capitalised Costs 25 25 25 25
Profit 51.8 8.6 2.2 -2.6
Margin 67.45% 25.60% 8.09% -11.61%

If a new game with the same sales profile is released each year with straight line amortisation applied we should get the results in the table below. We can see an initial exaggeration of profits which moves towards the real profit margin as the revenue stream includes an increasing mix of contributions from different parts of the sales profile:

Y1 Y2 Y3 Y4 Y5
Revenue Game 1 76.8 33.6 27.2 22.4
Revenue Game 2 76.8 33.6 27.2 22.4
Revenue Game 3 76.8 33.6 27.2
Revenue Game 4 76.8 33.6
Revenue Game 5 76.8
Total Revenue 76.8 110.4 137.6 160 160
Capitalised Costs 25 50 75 100 100
Profit 51.8 60.4 62.6 60 60
Margin 67.45% 54.71% 45.49% 37.50% 37.50%

If a new game is only released every other year, we see a different effect - the reported profit margin settles into a pattern where it continually alternates between fixed high and low points and we never get a true picture of what the overall margin is. I’ll just show the chart for this one:

Margin Example for Biennial Game Releases with Straight Line Amortisation

Finally if we apply this model to Frontier’s previous release dates and future roadmap we get this:

Margin Example using Frontier's Release Schedule and Straight Line Amortisation

Now we can see both of the effects described above. In the earlier years, Frontier was only releasing games every other year and we can see an alternating effect on margins before 2020. The projected profit margin is understated in 2021 due to a lack of a new game release. After 2021 the release frequency increases to roughly one per year and margins are then overstated for several years with the effect being enhanced by the double release being planned for 2022. The projection eventually converges on our actual margin figure for this example (37.5%) but not until 2026. Now compare the shape of the highlighted area from 2016-2020 in the chart above to Frontier’s reported EBIT margins:

Frontier Reported EBIT Margin

Look familiar?

So, to go back to my original question - does the phasing of game releases neutralise the impact of Frontier’s straight line amortisation policy on reported profits? Not today, but maybe at some point in future with the right combination of sales profiles and regular fixed intervals for new releases. How long will we have to wait? Come back in 2026.

Hi MIA1,

Yes, agreed. Once FDEV increases the game frequency, the mismatch between total revenue and amortisation will lessen with, as you say, the right combination of sales profiles and regular fixed intervals for new releases. The underlying issue though would still remain – just obfuscated by FDEV developing more games.

I suspect the accounting may not be too concerning for shareholders that focus on cash. The basic reality is FDEV spends £X on developing a game over a few years, then after launch receives £Y sales less £Z ongoing ‘support’ costs in return.

What we need to determine is (Y less Z) / X = which is the theoretical return on the development investment for a game.

Very rough figures…

Total capitalised development costs between 2012-2020 = £80m (my figures go back to only 2012 and I assume some Elite Dangerous development costs were capitalised prior to its 2014 launch).

Total operating cash flow between 2014-2020 = £104m.

So invest £80m and get £104m back – with more to come from future sales of the existing games.

Arguably development costs for 2020 (£21m) will not yet have earned a return, which then implies total development costs of £59m have earned a total cash return of £104m to date. These numbers do not look that bad.

I am sure FDEV must perform similar calculations before committing to a game, i.e. compare the total expected development cost vs. NPV of ((expected unit sales * unit sale income) less admin/distribution costs).

I am sure a case can be made for FDEV looking beyond the amortisation issue, as ultimately the valuation will be dictated by the NPV of future cash flows. But trying to work that out by assessing FDEV’s earnings for now remains inappropriate given the amortisation distortion between earnings and cash flow.

Maynard

Hi Maynard,

Saw this bumped recently so thought I’d signup as I’m currently looking at another gaming company (ALFOC - Focus Interactive), which as of a couple of years ago looks to have adopted the same policy as the companies previously mentioned.

Their amortisation period is 12-24 months so again confirms that Frontier’s period is unsually long.

You mentioned “I suspect the accounting may not be too concerning for shareholders that focus on cash.” How do you arrive at a FCF figure for companies which captitalise their development costs? Take these figures:

Surely I should not add back Amortisation when calculating FCF, as that is effectively employee salaries?

Thanks!

Hi formerboglehead,

Thanks for the post and welcome to the forum.

That’s interesting. I experimented with the ‘bump’ facility last night to see how it works, and just switched it off this morning as the home page looked strange with a load of old posts. But clearly this old post has attracted you, so I will switch the ‘bumps’ back on!

Best to look at the cash flow statement. For Focus Interactive for FY 2021, I would subtract capex of 40,521 from net cash from operations of 36,952 to arrive at a negative 3,569.

Bear in mind cash flow can fluctuate from year to year due to timing issues or one-off events. The figures for FY 2020 for example show a large 19,597 receivables movement, which seems odd/large versus the FY 2021 comparable.

Amortisation does reflect salary costs, but its size and relevance will depend on the useful life applied to the associated intangible. What the cash flow statement does is add back amortisation (the A in D&A, 25,813 for FY 2021) to earnings (13,278), and then subtract the actual cash capex (the aforementioned 40,521). That way for FCF calculations, you are not double-counting salaries by subtracting both amortisation and the actual cash expense. Hope that makes sense!

Everything below the 40,521 figure in the cash flow statement for FY 2021 can be considered ‘optional’ cash expenditure (such as acquisitions, dividends etc) or related to external sources of cash (such as debt proceeds/repayments), and can be ignored for FCF calculation purposes.

Maynard

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Hi Maynard,

I’ve been lurking for a while and thought they had all received new replies! So perhaps the feature wouldn’t be as useful for regulars who might make the same assumption, but can certainly see the benefit of bringing older posts to light again as in this case (for me).

Thanks for going into more depth on this. I had initially assumed the capex to be acquisitions (which they have made several of in the past year), though looking at it again I see these listed separately.

I find it odd that the restated 2020 figures don’t include a similar capex spend, as the amortisation and depreciation changes started in that period:

Gaming companies are certainly cyclical, but I would’ve expected year-on-year development costs to be a bit more consistent for a publisher.

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Hi formerboglehead,

Is that table produced by the company or a summary of the financials from elsewhere? Could be wrong if it is from elsewhere. The 23.87 and (23.23) figures for FY 2020 look incorrect to me.

Maynard

Hi Maynard,

No this is from Tikr, which I’ve been trying out during the free beta. I think you’re right about the figures being incorrect - perhaps Tikr hadn’t updated after they were restated for 2020.

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Oh dear. FDEV has warned on sales following a slow take-up of some new releases:

"Jurassic World Evolution 2 will be our biggest release and our largest revenue contributor in this financial year FY22, the 12 months to 31 May 2022. Based on the lower initial PC sales noted above and the under-performance of Odyssey in the financial year to date, we are prudently updating our revenue guidance for FY22 to £100 million to £130 million. The wide guidance range is indicative of the variability of outcomes across our whole portfolio as we approach the important holiday season (Thanksgiving and Christmas)."

Annual results published during September had said:

Based on the anticipated ongoing performance of our existing portfolio, combined with an exciting new release schedule for FY22, the Board’s projected revenue range for FY22 is £130 million to £150 million, implying an annual growth rate of 43% to 65% above the record revenue reported for FY21.”

So mid-point FY22 sales have been downgraded from £140m to £115m, or £25m.

But FDEV reckons sales of Jurassic World Evolution 2 (JWE2) will eventually pick up:

We continue to project Jurassic World Evolution 2 to overtake Jurassic World Evolution in terms of revenue in its first 12 months from release. We believe the initial PC sales are primarily a phasing issue, where we expect further significant sales around Christmas, with excitement strong on PC (with over 440,000 on the Steam wishlist). Sales in the first 12 months will also benefit from the launch of the Jurassic World Dominion film in June 2022.

Will be interesting to see if sales of JWE2 do actually pick up. I get the impression successful computer games are successful right from the launch. As I wrote in this topic above:

Will also be interesting to see how FDEV treats the intangible expenditure relating to JWE2. Amortise as normal over 3-5 years? Or will the slower sales prompt an accelerated impairment?

I remain unconvinced about FDEV’s amortisation policy as explained in the first post of this topic:

From FDEV’s 2021 annual report:

For FYs 2020 and 2021, aggregate cash development costs came to £42m versus £24m expensed as amortisation. The gap remains large compared to others in the sector.

What seems worrying now is the extra intangible spending on “Game technology”, which relates mostly to FDEV’s ‘COBRA’ development system.

Between FYs 2012 and 2019, FDEV spent a cumulative £6.3m developing COBRA and matched that expenditure with an amortisation charge of £7.6m. So no problems there.

But the COBRA expense has since ramped up, with an aggregate £10.2m spent during FYs 2020 and 2021. The amortisation charge has meanwhile not really kept pace at an aggregate £2.3m for those two years.

Capitalising COBRA costs does seem strange to me. Essentially FDEV is capitalising costs of developing a system that in turn helps develop games, the costs of which are also capitalised. The amortisation of capitalised game costs starts when the game is launched, but the annual report does not make clear when amortisation of the COBRA costs start (when the associated game is launched?).

Suffice to say the accounting here is not straightforward. I also don’t like how the company has started to develop games for F1 and Games Workshop. After all, the business was built on the in-house Elite game and relying on (and paying for) third-party IP suggests the business has run out of its own ideas.

Note the directors enjoy a bonus based on reported operating profit:

FDEV AR 2021 bonus

So… capitalise some extra COBRA costs and double your take-home pay through a bonus!

I should add that not everyone agrees with my view. Phil Oakley wrote about FDEV in the Investors Chronicle exactly a year ago: FDEV philoakleyIC 20Nov.pdf (1.6 MB)

Update: Phil has now “gone cold” on FDEV (from 28:20):

Maynard

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Hi Maynard,

It’s all about incentives, imo. Also, the auditors tend to check compliance with the company’s own rules (subject to GAAP). What you or I may think is unfair, the Directors can implement within reason.

I personally wouldn’t worry about the switch to 3rd party development too much. This is what Team17 Group and Keywords Studios do, and it is a good business model. Agreed they won’t smash the ball out of the park if they happen on a game that trends and has legs, but the company’s individual investment risk for each game developed is less. Hopefully this makes for a less volatile share price! (I hold TM17).

image

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Regards,

anon

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Hi anon

I suppose the worry is FDEV has been built on its own IP, but has now started becoming dependent on somebody else for game ideas. So the model as such is evolving, which may be good or bad, but the economics of the business are likely to change. The recent warning highlights how follow-up versions to previous big-sellers have not really worked, so perhaps the reasoning for the F1/GAW deals is becoming apparent.

TM17 has the better approach; not dependent on a handful of blockbuster games, but instead a collection of in-house titles and a bevy of co-productions with small-time developers.

KWS I believe is mainly a service business, whereby third-party developers pay KWS for help with artwork, voice overs, translations etc.

Maynard

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Yes, KWS provide services to game developers amongst others, as well as being a kind of market research agency for gaming. They do enhance the game coding, but maybe don’t build the game from scratch.

Regards

anon

Hi Maynard,

Yes, as you demonstrated in your previous posts the initial launch period will be extremely important, giving an indication of how successful the game is likely to be. All eyes will be on the new year trading update which should tell us if sales of JWE2 improved over the Christmas holiday period.

I do think that the longevity of Frontier’s games makes the initial period less significant as a fraction of the total cash generated thereafter than it might be for games from other providers that can have much shorter lifespans.

Below are updated annotated versions of the Planet Coaster and Jurassic World cumulative cash generation charts from Frontier’s latest presentation slides for comparison with the ones from your earlier post. We can see from the charts that the initial 2 month period currently accounts for ~30% of the total for Planet Coaster and ~50% of the total for Jurassic World. Still very significant, but in your charts from a year ago, these figures looked more like ~65% and ~85%.


What is interesting about these charts is that the cumulative sales are not flattening off several years after the original game releases. For me this is a validation of Frontier’s ‘Launch and Nurture’ strategy, staggering releases on different platforms and releasing paid downloadable content (PDLC) to boost revenue streams. You can see the effects of some of these in the charts. I’ve added annotations showing the console release of Planet Coaster, and PDLC and Nintendo Switch releases for Jurassic World.

I don’t think it’s such a bad idea. One of the reasons that I believe Elite Dangerous has been so successful is that it was able to leverage and build on the existing IP and cult following of the original 1980s game. Elite also has a lot of scope for adding new narratives via expansion packs. I see a lot of similarities with the characteristics offered by Games Workshop’s fantasy worlds.

That was a great spot! Agree with your points on capitalisation of COBRA costs. Feels like the directors have a lot of scope to control their own destiny here.

Frontier’s portfolio size and release rate does need to reach an inflection point in order to stabilise its revenue streams, but I’m not sure it is that far away. FY21 reported 19% revenue growth and 20% operating margin without a major game release. Even after this week’s downgrade, the mid point of the new projected revenue range still represents 27% growth over FY21. Frontier’s 3rd party publishing label, Frontier Foundry, also reported its first revenue in FY21. The company is planning at least four releases per year through this label. Here’s what the company says about Frontier Foundry in the FY21 Annual Report:

Over the next few years we plan to establish Frontier Foundry as a significant business, generating a material proportion of Frontier’s revenue and profit.

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Hi MIA

Yes, the cumulative cash chart looks more favourable now than it did last year. The shelf-lives of these games have indeed lasted for 3-5 years and the early sales are smaller proportions of the cumulative total.

What looks impressive is the cash payback on the initial investment.

The chart suggests the three games have earned a cumulative cash return of 3x, 4.5x and 7x on the respective pre-launch development costs:

This gives some idea to the question I raised earlier in the topic:

Perhaps if the P&L is adjusted to exclude all research & development costs, we could derive ‘residual’ earnings from FDEV’s launched games. Contrasting those earnings to the current market cap would then gives us an idea as to how the market values the titles under development.

So more rough sums… FY 2021 operating profit of £20m with £22m of R&D added back gives £42m less standard 19% tax = £33m. Versus a £690m market cap = 20x. Is 20x fair for the ‘residual’ earnings of all the launched games with no further development? If so, the shares are pricing in nothing for the titles under development which could mean the valuation is attractive.

True, but the agreements do feel as if FDEV is changing tack a little. A lot depends on the agreement fine print – at least with Elite you know all the income accrues to FDEV!

Maynard

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Market cap now £530m with the shares at £13.50 following these H1 results:

Rough sums still suggest trailing 12-month operating profit with R&D added back is £42m, which gives earnings of £33m at standard 19% UK tax. So I think we are presently paying 16x for the ‘residual’ game-catalogue earnings with no further development.

RNS also referred to “accelerated amortisation”:

R&D amortisation charges related to previously capitalised development costs grew 73% to £12.2 million (H1 FY21: £7.0 million). Charges in H1 FY22 included a full six months of amortisation for major expansion Elite Dangerous: Odyssey and one month for Jurassic World Evolution 2, as well as an accelerated amortisation charge for Lemnis Gate following its relatively low sales performance at release.

A small admission perhaps that the amortisation policy may not always be entirely conservative?

Maynard