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11 June 2020
By Maynard Paton
Has the market become too obsessed with ‘pandemic-proof’ shares?
I ask because my SharePad screening has brought Frontier Developments to my attention.
The shares of this computer-game developer have leapt 66% so far this year as industry sales rally during the lockdown.
However, Frontier’s accounting looks rather questionable and the near-£800 million market cap seems completely mad. Yet nobody seems to mind given the company’s apparent resilience to Covid-19.
Read my full Frontier Developments article for SharePad.
Maynard Paton
PS: I have also compared Frontier’s accounting to that of Team17 and Codemasters.
PPS: I have provided further Frontier observations on the Quidisq forum.
Frontier Developments (FDEV)
Comparison with Team 17 and Codemasters
The accounting issue with Frontier 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
Frontier Developments
Reader question
A blog reader has contacted me about my Frontier article for SharePad with some good points. I thought I would make the points and reply public for anybody else who is interested:
Here are the points:
“Firstly, in the 2019 annual report, page 53 it writes “The majority of amortisation charges for intangible assets are expensed within research and development expenses.” – so they capitalise as an intangible as then take an enhanced deduction for it – and on page 22 it says that the capitalisation policy was changed on 1st June 18 to only capitalise new products and enhancements under IAS38.
The risk is flagged under the audit comments on page 37 where they highlight the capitalisation of intangible assets as the biggest risk and they detail the audit steps taken which all seem reasonable. I wonder what your thoughts are on this.”
Here is my reply:
“Always best to compare questionable accounting policies to the relevant policies adopted by others in the sector, to get a better feel for what is going on. I have compared FDEV to TM17 and CDM here: See what you think.
Key audit matters and the associated steps always seem reasonable. Sadly auditors aren’t paid to protect investors (c.f. Patisserie Valerie), which means we simply have to make our own minds up whether the accounting is prudent or not. FDEV has appointed new auditors for its 2020 books, so the policy may (or may not!) come under fresh scrutiny. “
Maynard
Thanks for this brilliant insight.
Thanks Jay
Frontier Developments (FDEV)
Further discussion concerning FDEV’s accounting can be found on Quidisq.
Maynard