Eidos -- the Bear Case

By Maynard Paton (TMFMayn)

I'm trembling at the very thought of writing this feature. Having perused the busy Eidos message board, it appears no one is an out and out "sell" on Eidos. In fact the word "sell" is non existent, on a board littered with, it must be said, quite accurate short predictions of rapid share price growth.

The nearest I could find that came anywhere close to an Eidos bear was this post: http://boards.fool.co.uk/Message.asp?id=2100003000117000&sort=postdate.
Bmills writes: "I am in no way suggesting that eidos is a sell, just that it is one of the slower items in today's heated market". Not exactly the analytical insight I was hoping to help me start this feature...

It looks like I'm going to be on my own with this one. So with thoughts of the Foolish long term buy and hold in mind, I'm ready to take on Ms Croft...

1) Computer Games -- just a series of technology-led fads.

Let us take a trip down memory lane. Who remembers the Atari cartridge system of the very early eighties? The Dreamcast equivalent of the day. Everyone had an Atari in the front room, playing the likes of Space Invaders, Pac Man and Pole Position.

Then not so long after Atari, came cheap home computers. The Sinclair Spectrum, Commodore 64 and BBC Micro started to enter every teenage boy's bedroom. The additional computing power and flexibilty of these machines gave scope for far more complex games. Different games and additional "characters"
suddenly appeared on the scene. Atari was dead. Buried alongside the out-of-date console were the games. Rest in peace, Pac Man.

Wasn't Jet Set Willy the greatest selling Spectrum game ever, based on a man running through a house? And Elite, a game revolving around flying a spaceship around the universe, was the biggest winner for the BBC Micro. These computers had about four years at their peak. The introduction of the Commodore Amiga and Atari ST, and the beginning of the mass-market PC effectively killed off the Spectrum et al. Mr Willy, the Elite space craft and countless other "characters" who had a year or two in the sun were quickly laid to rest.

Moving into the nineties, and games specific consoles were now back in fashion. Enter Nintendo. Was Super Mario your favourite SNES game? Maybe you had a Sega Megadrive instead, and thus Sonic the Hedgehog was your preferred gaming companion. Where are Mario and Sonic these days? In the rather large Computer Game Character Graveyard, resting alongside Pac Man and Jet Set Willy -- executed by the neverending technical revolution.

There is a definite trend in the history of the computer game. With every advancement of hardware, so came a new progression in software. And with the software came novel ideas and fresh game characters, to fulfil the potential of the innovative computing platforms.

Life spans of the aforementioned gaming "characters" were about two to three years maximum. In the ever changing world of computer games, you cannot count on any long term "character" predictability. And you need a certain amount of predictability in demand for a ompany's product to justify a long term buy and hold investment.

Eidos will have to overcome this brief shelf life nature of the computer gaming market. I seriously doubt even Lara will change the historic nature of this short term faddish industry. I've no doubt that hardware platforms will continue to evolve. Hand me a chisel and I'll start on Lara's tombstone right now.

2) Lara -- seen her best years.

Up to now Eidos have used Lara Croft to great effect. Sales of her Tomb Raider game made up over half of Eidos' revenues in the year to 31st March 1999. The whole growth of the company so far has revolved around the success of the immensely popular Ms Croft. Having arrived at a unique, imaginative and, err... attractive character, for the typical teenage boy computer gamer, the difficulty for Eidos is now going forward.

It's going to be nigh impossible for Eidos to match the success of Lara with another character. And just how far can the Lara character be stretched in the future before her time is up? Already on to Tomb Raider IV soon, is it really necessary for parents (for it is them who buy these games) to splash out on the latest £30 or £40 Lara game? I fear not.

A quote from no less than Durlacher's (LSE: DUR) GamesInvestor site (http://www.gamesinvestor.co.uk), sums up the future Lara revenue problem for Eidos:

"As it stands, though, the Company (Eidos) also appears to have peaked in its year-on-year organic sales growth and in the absence of further Tomb Raider-sized stories, revenue growth for FY00 will likely be lower than in previous years"

Lara fans shouldn't get too carried away with other streams of Tomb Raider income either. The much vaunted Tomb Raider film is only reportedly to bring Eidos around £6m profit, hardly massive compared to the £54m expected this financial year. And it is worth bearing in mind the "success" of other computer games revamped for the silver screen. I don't remember Bob Hoskins winning an Academy Award for "best actor" in the disastrous Super Mario film.

3) Post Lara -- Eidos bereft of original ideas.

With Lara saturation not far off, Eidos have quite sensibly tried to broaden their product range. The trouble here is that Eidos, after the one off success of Lara Croft, look totally lost. Eidos are bereft of further organic growth and imaginative ideas and instead have embarked on a "growth by alliance and acquisition" strategy.

So leaving the in-house developers to concentrate on Ms Croft, Eidos have had to go and effectively "buy" ideas for further growth. There are two parts to this "strategy". One part has seen Eidos purchase a string of minority stakes in external game development companies, that have existing "content". In these deals, Eidos buy the publishing rights to existing game titles and provide upfront non-refundable royalty payments for the subsequent game developers. The risk here is that with a non refundable upfront payments, you don't get your money back if the game doesn't sell.

It's interesting to note that Royalty costs to third parties in the year to March 1999 increased 150%, over double the rate of turnover growth. A sign of increasing costs and future pressure on margins for Eidos, I believe. Stakes in development companies don't always go too smoothly. A stake in Ion Storm, and a reported advance from Eidos of £16m, still didn't lead to any new game produced after three years.

The other part of post-Lara strategy is to become a licensee of a famous name. Again, Eidos pay for ideas. New publishing rights range from a football game under the Michael Owen name, a football game under the UEFA name, the official Formula One racing game and three games based on Disney (NYSE: DIS) ideas, one of which is Walt Disney World Racing (another motor racing game). So, two extra football games alongside the existing Eidos published games of Championship Manager and FA Manager. Can the world cope with all these Eidos football games? And yet more motor sport games?

Plus there is no guarantee in the future that Eidos will receive the same sought after licences from the likes of Disney etc. There are plenty of larger players competing with Eidos in the same publishing industry.

In the end, constantly paying and relying on third parties to develop future growth is not the way forward for any long term investment proposition. The stock market is prepared to apply generous ratings to stable Lara Croft profits generated organically, but it remains to be seen how the market assesses unproven acquired growth.

However, there are more issues, although not fundamental, that do add up to more concerns with Eidos.

4) Cash Conversion.

On to the financials. We all know how cash is important to a business. A basic ratio to measure a cash flow performance is the cash conversion ratio. It's described in the Motley Fool UK Investment Workbook thus:

                        Net cash from operations
Cash conversion ratio = ------------------------
                            Operating profit

The Workbook mentions that "a company with a cash conversion ration of less than 80 per cent ought to be treated with caution".

This is Eidos' recent record.

                                           1999             1998

Operating Profit                           9,170          19,453
Depreciation                               3,539           2,830
Amortization of Goodwill                   4,632               -
Loss on disposal of fixed assets              16              47
Increase in Stocks                          (373)         (2,906)
Increase in debtors                      (28,644)         (3,664)
Increase in creditors                     11,728             104
Net cash from operations                  30,068          15,864

The cash conversion ratio comes in at a poor 76% for 1999 and scrapes the Motley Fool benchmark at 81% in 1998. Do as the book says -- treat with caution.

5) Fanciful foreign investments.

In 1998, Eidos created a 50/50 joint venture with Opticom ASA, a Norwegian company that it already has a 15% stake in. The joint venture cost US$5.5m dollars and Eidos have since ploughed in another US$3.3m as at March 1999. What does this company do? It has been trying, unsuccessfully for twenty years, to develop a method of storing data on plastic ("polymer storage") rather than using conventional microchips. Eidos are just throwing money away. Are shareholders in ARM Holdings (LSE: ARM) worried? Highly unlikely.

6) Fat Cats and Kittens.

Corporate governance appears to have gone awry at Eidos. No less than six points in the Principles of Good Governance were not adhered to from the 1999 annual report. Worryingly, a comprehensive review of all the "controls" operating within the group performed during the last full financial year highlighted a number of weaknesses, "particularly in the respect of directors expenses".

Alongside a string of related party disclosures, directors are eligible to receive "discretionary" bonuses. No performance hurdles are given, yet it seems extremely generous to reward Mr Heath-Smith, whose basic salary is £204,167 a bonus of £3.7m for his "enormous contribution". But it is interesting to note that Mr Heath-Smith is managing director of the Eidos "Core" subsidiary, responsible for Lara Croft. Another indication that Eidos are a one product company, and are doomed to depend on Lara.

Large pay packets are not the preserve of the board though. The typical employee at Eidos was paid £56,000 in 1999, against £46,000 last year, a 21% wage hike. Lets hope sales growth can outrun directors and employee wage bills at Eidos.

7) Bringing imaginary violence into reality -- and paying for it.

Through their violent games, Eidos have got themselves caught up in a mighty legal battle. The foundation for the claim is playing video games was a cause of an American High School shooting in 1997. Apparently video games and television made "violence pleasurable and disconnected it from reality". There are twenty four other defendants and the damages claim is in the region of US$100m. A definite dark cloud over Eidos. Scary.

In closing.

The first three points are the main stumbling blocks when considering Eidos as a long term buy and hold. Fundamental computer game "character" boom and busts, historic growth based on one single character and heavy reliance on third parties and acquisitions for future growth is enough to keep any sensible investor well away. The other four points just add to the warning signs. The entry price in Eidos today, around 6000p discounts substantial future growth. Earnings are forecast to grow around 15% for both this current year and next. At 6000p, the shares stand at a heady rating of 34 times this year's profits, moving to 30 times for the year after. Far too rich given the aforementioned uncertainties.

Related Links

Durlacher Games Investor website: http://www.gamesinvestor.co.uk

Video game Graveyard:
http://videogames.gamespot.com/features/universal/graveyard/arcade2.html

Death to Lara: http://www.geocities.com/TimesSquare/Corner/6540/list.html