Around the Markets:
Stocks fell and bond yields jumped in the week ended February 10 as investors contemplated the potential for higher peak interest rates after a slew of strong economic data. Bloomberg’s World Interest Rate Probability is now estimating a peak Federal Funds rate of 5.2% vs. an estimate of 5% last week, based on the futures market.
Source: Bloomberg
Note: Bond yield change in basis points
Sports Betting Eyes Another Record Handle at Super Bowl LVII.
With Super Bowl LVII upon us, online sports betting is preparing for another record haul. In 2022, legal online sports betting took in $1.1 billion and Bloomberg Intelligence estimates that this year’s handle could grow 20%.
Our Take:
With three new states legalizing online sports betting for this year’s big game - Kansas, Maryland and Ohio - it seems as easy as an extra point (not the Dallas Cowboys kind) for the total handle to reach a new record. Focus may thus shift to the size of average bets and the win for online sportsbooks, as the industry’s increasing scale augurs for a shift from a land grab for users to profitability.
Since 2018, when the federal sports betting ban was lifted, the handle grew from $159 million to $1.1 billion in 2022, a CAGR of over 60% during the period. Although 2023’s growth is estimated to mark a slowdown from those high levels, it’s partly due to the fact that the industry is reaching a critical mass of states in which it is legal. Last year’s near doubling of Super Bowl bets was driven mostly by New York legalizing online sports betting. The CAGR for 2018-21 was a more reasonable 45%.
According to Action Network, sports betting is now legal in 35 states, with full mobile betting legal in 20. As the market nears a critical mass, inevitably the growth rates around key events like the Super Bowl will slow, and the onus will fall on operators to drive user retention, increase the revenue per paying user and drive towards profitability.
Investment Themes
Sports Betting
Nintendo slips on weaker Switch outlook ahead of big software year.
Nintendo’s shares fell 7.5% after the company lowered its outlook for Switch hardware and software shipments for the year ending March, 2023, signaling that demand is slowing amid a difficult economic backdrop, increasing competition in console gaming and a weaker new game release slate. Despite supply chain bottlenecks no longer proving a hindrance to sales, Nintendo now expects to sell 18 million Switch units in the current fiscal year vs. a prior outlook for 19 million. And due to lower hardware sales, it also now expects to sell 205 million units of software vs. a prior outlook for 210 million.
Our Take:
The Switch cycle is coming to its inevitable late-stage, where hardware units decline and the onus is on Nintendo to sustain a constant release cadence of new games to maintain high levels of software sales to profitably monetize its user base. Still, it’s important to remember that, in its seventh year since launch, the Switch is on pace to sell more than 4x the number of units than the Wii did in its seventh year. So although the platform is slowing a bit faster than expected, it’s still been highly successful. The Switch has already outsold the Wii by about 20%, is already Nintendo’s highest-selling home console ever and still has room to grow. The environment for gaming companies has gotten much more difficult and Nintendo’s revised guidance reflects this. With rampant inflation and an uncertain economic backdrop, it’s evident that consumers are focusing their spending on a smaller subset of bigger blockbuster and high quality games, rather than spending across a broader suite of titles. This was noted by gaming peers including Electronic Arts and Take-Two. For Nintendo, this was evident in some of its smaller titles such as Xenoblade Chronicles 3 not selling as well as prior comparable games, even as blockbuster releases like Pokemon Scarlet and Violet seeing strong sales.
Looking ahead, Nintendo software sales could bounce back in fiscal 2024 with the release of The Legend of Zelda: Tears of the Kingdom in May, the sequel to The Legend of Zelda: Breath of the Wild, which has so far sold 29 million copies. Pikmin 4 is also scheduled for release in calendar 2023 and the next installment in the Metroid Prime series remains in the company’s pipeline but lacks a release window. So it does look like Nintendo is primed for a strong software bounce back in 2024, even if hardware units continue to drift lower.
As hardware sales slow, attention will also shift to any commentary around future hardware platforms to succeed the Switch. Although the company hasn’t put any firm dates around future platforms, the Switch is nearing a point where its hardware is being fully maxed out and future, more immersive and higher quality game experiences will likely require more advanced hardware. The Wii U launched four years after Wii shipments peaked, which would suggest a successor to the Switch is two years or so out.
Investment Themes
Gaming
Call of Duty “Nukes” the competition, but Activision awaits Microsoft M&A play.
Activision Blizzard shares rose 5.6% after the company reported strong 2022 results and 2023 outlook on February 6, 2023, fueled by record results for its Call of Duty franchise and new releases from Blizzard. Still, investors await clarity on the company’s pending $69 billion acquisition by Microsoft, which is facing intense regulatory scrutiny globally, including by the U.S. Federal Trade Commission and the U.K.’s Competition and Markets Authority.
Our Take:
Activision’s results were blowout across the board, fueled by Call of Duty. Call of Duty: Modern Warfare II delivered the highest launch-quarter sell-through in franchise history, with robust digital sales and cumulative hours played through the end of 4Q the highest in franchise history at this stage of its release. Warzone 2.0 also contributed to high engagement and net bookings. And even Call of Duty: Mobile grew double-digits year-on-year. While competitors saw their own free-to-play games struggle in the quarter, Activision was clearly taking market share of time and money spent away from the likes of Apex Legends and Grand Theft Auto Online.
Blizzard also saw very strong 4Q results, with net bookings and operating income rising 90%. World of Warcraft benefitted from the release of the latest expansion in the series, even if it trailed prior expansions’ financial performance. Diablo Immortal remained a strong contributor and the release of Overwatch 2 contributed to strong results as well.
Looking ahead, Call of Duty’s full year of new content should sustain growth into the fall’s next release in the franchise before year-ago comparables get more difficult in 4Q. It also appears that Warzone 2.0 engagement has started to tail off and it will be seen if Activision can retain users while competition remains fierce for gamers’ time and spending. Blizzard sales are expected to grow in 2023 despite ending service in China, mostly fueled by the planned release of Diablo IV.
But all eyes remain fiercely glued on the company’s pending merger with Microsoft for $69 billion. The market is currently pricing in roughly a 50% chance the deal goes through, with particular focus on the U.K., which is expected to make an announcement soon in regards to its initial findings. On a standalone basis, Activision is executing quite well on its key franchises but the merger overhang will continue to dominate the headlines.
The U.K. CMA on February 8 preliminarily found that the deal creates consumer harm and is seeking a new round of comment on whether to impose structural or behavioral remedies or block the deal outright. The final deadline for the CMA to publish its report is April 26, 2023.
Investment Themes
Gaming
Canopy Cuts 60% of Jobs Amid Cannabis Market Reset.
Canopy Growth shares fell 17.2% after announcing it will cut 60% of its jobs and shift to an asset-light model, exiting the growing of cannabis, as the market has failed to live up to expectations. This is due to the ongoing difficulty of regulations and competition from the black market. Canopy is also now pivoting its growth expectations away from the Canadian market and towards the U.S. in a bid for sustainable profitability.
Our Take:
The name of the day is profitability and these latest, drastic cuts by Canopy put it on a trajectory to achieve that if it can execute against more rational expectations. Canopy’s struggles highlight the challenges faced across the industry, where a patchwork of regulations across the U.S. and the inability of Canadian regulators to stamp out the black market make it difficult for legal operators to compete. Canopy’s latest job cuts position it to save between C$140-160 million in expenses and achieve breakeven EBITDA in fiscal 2024, but that may not be enough to sway sentiment just yet. Until the regulatory and operating environment improves, it’s going to remain tough for legal operators to achieve significant profitability.
In the past and not dissimilar to other high-growth sectors, it was a land grab for market share at any price. In the current environment, investors are focused on profitability and reasonable growth. The onus is on Canopy and the cannabis sector to show that they are serious about reigning in costs and operating profitably to win back investor trust.
One concern of focusing on the U.S. market remains its U.S. subsidiary, Canopy USA. Currently, Canopy Growth does not consolidate its U.S. operations, enabling it to list on the NASDAQ exchange. But the NASDAQ rules have said that if it consolidates its U.S. operations, its U.S. shares would get delisted. The company is working on alternatives to avoid consolidating these assets to maintain its U.S. listing.
Investment Themes
Cannabis
Take-Two cost cuts drive rally despite an earnings and outlook miss.
Take-Two shares rallied over 7% on February 7th after the company announced additional cost cutting measures despite posting fiscal 3Q 2023 results and 4Q23 guidance that trailed consensus estimates. The announced cost cuts of $50 million, targeting mostly corporate and publishing employees and not affecting development teams, are in addition to the expected $100 million of synergies Take-Two had expected from its acquisition of Zynga.
Our Take:
Similar to peer Electronic Arts, key blockbuster titles like NBA 2K performed strongly in the quarter but weakness was felt in some smaller new releases such as Marvel’s Midnight Suns that underperformed expectations and competition for live services games like Grand Theft Auto Online from Activision’s Call of Duty: Modern Warfare II and Warzone 2.0. In this tough macroeconomic environment with consumers focusing their budget on a smaller subset of higher-quality, blockbuster games, it’s harder for smaller titles to perform.
Notably, the company’s fourth quarter outlook calls for a 28% sequential drop in recurrent consumer spending, which encompasses the revenue Take-Two earns from its live services games like Grand Theft Auto Online and Zynga’s mobile games. Although this was far worse than expectations, investors may see this as the bottom for results and, along with the cost cuts, think that the worst might soon be past.
It’s also important to note that Take-Two has massively underperformed EA in the last year, so cost cuts and expectations that the worst might soon be past might have been enough to generate optimism in the face of, at least on paper, weak numbers. Take-Two’s shares in the 12-months through Feb. 6 were down 35.5% vs. EA shares down 12.9% over that period.
Investment Themes
Gaming
AppLovin Surges as Mobile Market Stabilizes, Profit Outlook Strong.
Mobile advertising specialist AppLovin’s shares surged over 25% on February 9 after the company provided better than expected fourth quarter results and an outlook for 1Q profitability that was well ahead of expectations. Given the stock sold off 88% in 2022, this probably represented some degree of relief rally as well.
Our Take:
AppLovin’s results and guidance suggest that the worst is past for the performance marketing specialist. The company has focused hard on cost cutting and optimizing its operations for a more muted economic environment, and it’s paying off. The company’s guidance for 1Q adjusted EBITDA of $250-270 million. At the midpoint, this is 4% above consensus and represents 10% year-on-year and 40% sequential growth. The company also said that it sold off several of its less profitable game development studios and now has 11 owned and partner studios that are better positioned for the more muted operating environment and can maintain better profitability.
According to CEO Adam Foroughi, the mobile market has stabilized and AppLovin is beginning to execute better in a tough operating environment. Mobile advertising specialists had to significantly adjust their business models in 2022 after Apple changed its privacy standards, reducing the ability for advertisers to directly target individuals on the platform. As such, mobile game makers, who represent the bulk of AppLovin’s business, could no longer “whale hunt” and have had to significantly change their development strategies to make games that focus on monetizing a larger cohort of players than traditional models that relied on heavy spending from a small percentage of users to subsidize the large percentage of players that don't spend.
Foroughi said that mobile game companies have adjusted their advertising models and are seeing better trends as the industry reaches this inflection point. With AppLovin planning to rollout the next generation of its Axon recommendation engine with advanced AI and machine learning algorithms, advertisers should see better value from the platform and further entrench AppLovin’s leading market share.
Investment Themes
Gaming
Chart of the Week
In 2018 when the federal ban on sports betting was lifted, $159 million was bet legally on the Super Bowl.
Last year, over $1 billion was wagered on the game — more than doubling 2021’s total.
