Square Enix shrugs off risk worries after Marvel Avengers disappoints

Square Enix tells shareholders that one game's sales miss won't affect other titles that're in development.

While scouting Square Enix's FY2021 earnings report I noticed something interesting. Company President Yosuke Matsuda recently discussed write-downs and assuaged investors that one game underperforming in sales doesn't hurt Square Enix's production account.

Here's the gist: Square Enix has a content production account that's kind of like a big piggy bank that stores all the money used for game development. This account expands as needed; when the teams need more money for a game, Square Enix funnels more cash into the account.

This account has an actual and perceived value. The actual value is what Square Enix pays. The perceived value is the estimated and forecasted value of the account which includes the guessed value of specific projects when they release. When the perceived value of the account is lower than the actual value, this is a loss, and Square Enix does a write-down--an accounting method that allows Square Enix to lower its income tax rate.

Write-downs can be recorded as deferred taxes, which are basically tax credits that can be spread over time to help reduce Square Enix's tax payments over a set period. Everyone does this. EA's deferred tax credits directly contributed to its record $3 billion in profit in 2020.

This can happen with games that are already released, most notably live games. Think of Marvel's Avengers, for example. If Square Enix is paying more money on new Avengers updates than it expects to make from releasing them, then that value can be written off.

Write-offs also negatively affect net income but do not affect operating income.

It's also worth noting that when a game like Marvel's Avengers releases, the entire game's development costs are capitalized and recorded as expenses. These expenses are carefully spread across over multiple years to avoid paying big sums all at once.

All games companies do this, and CD Projekt recently did this with Cyberpunk 2077; CD Projekt is depreciating 60% of Cyberpunk 2077's total development costs 3% every quarter over a five-year period to keep the costs manageable.

When the Group determines that the estimated market value of the content production account-based on expected future demand and market conditions-has fallen below book value, the Group recognizes a write-down, while recording loss on valuation of inventories. If future demand and market conditions are worse than management's forecasts, there is the possibility that an additional recording of loss on valuation of inventories will become necessary.

Yosuke says that every game and product in its production account have been carefully planned out.

Each product has its own risks, costs, and perceived value associated with it. One game missing a sales target won't directly negatively impact another game. The company has taken all of these things into consideration and these numbers are the main glue that holds its forecasts together.

I will next discuss our content production account. To achieve our net sales target, it will be key that we establish a substantial pipeline of new titles and then release those titles to generate the sales that we are expecting. In short, our content production account is also a leading indicator for our future sales.

I will now speak to the current size of our content production account and to the risk that we will have to take write-downs on it. The account is a collection of individual projects, and we evaluate it based on each project, meaning [we apply] project-based costing. As such, by the nature of the account, we do not post impairment losses equivalent to a consistent percentage of the balance at the end of each fiscal year. Moreover, growth in the size of the account does not dictate a commensurate rise in write-downs.

Write-downs are the product of our assessment of the likelihood that we will recoup the account's costs based on our future earnings projections as of the end of each fiscal year. Major spec changes and other events that take place during the development process can also contribute to write-downs.

While Marvel's Avengers, which we launched in September, did not perform to our initial expectations, we were able to achieve our medium-term earnings targets of net sales of ¥300-400 billion and operating income of ¥40-50 billion thanks to the expansion of our base of stable recurring income from the MMO and Games for Smart Devices/PC Browser sub-segments.

I will note one more point. Because of how Marvel's Avengers sold in FY2021/3, you may be wary of the risk associated with our future releases. However, as I mentioned a moment ago, because we manage development efforts and earnings project-by-project and studio-by-studio, nothing that happens with any one title impacts the others. It is based on that premise that we will build a pipeline that will enable us to consistently generate net sales of ¥400-500 billion.