By Octo AM

Having dealt with allocation and monetary policy in our last two weeklies, today we’re tackling the case of a bond issuer that we find particularly unfavorable for an investor, in particular because its yield and credit premium have remained very low in relation to its credit quality, which has – or could – deteriorate significantly. The bond market is abundant and varied, so why risk an accident on bonds offering yields of between 4% and 5% that could tip over to 8% or 10% in the coming months, implying dozens of points of capital losses?

We’re talking about Ubisoft here.

While the company has been in the headlines for several weeks now, as its difficulties have been piling up, it has, for the time being, slipped through the cracks of the credit market. There are three reasons for this dichotomy, which occurs from time to time, and then always corrects itself:

• The absence of agency ratings has two consequences:
  • The absence of most constrained or indexed management: it is likely that the recent deterioration in quality would, for a rated issuer, have moved the company from the investment-grade segment to the high-yield segment, or at the very least placed it on negative watch, which would have alerted the market, implying a phase of disposal and hence spread widening. Unrated issuers tend to be positioned in satellite portfolios, less sensitive to financial news and technical flows.
  • The absence of the credit quality benchmark provided by the agencies, making issuers less subject to press articles on the subject and to “quantitative” issuer management.
• Outstandings mainly positioned in convertible bonds: although convertible bonds are indeed bonds, they are generally managed separately, by specific managers and in specific funds, whose analysis is more a 50/50 mix of equity and credit than a pure credit analysis. As a result, it often happens that a convertible bond, because of specific flows into these funds or erratic share behaviour, offers a yield that is significantly different, all other things being equal, from a conventional bond from the same issuer.
• An issuer that still enjoys a reputation for prudence and good quality. Often, particularly in the case of unrated issuers, there is a time lag of several years between actual credit quality and investors’ perception of that credit, either for the better or for the worse. Rallye and Atos, for example, enjoyed very good credit with many bond investors just a few months before they collapsed, even though financial analysis in the strict sense had already shown for several years the problems that led to their downfall.

(Sources: Bloomberg, Octo AM)

Here, then, are the factors that have prompted us at Ubisoft to sell our 1% position in the OR2027 fund on 09/09/2024. Obviously, these arguments are only warning signs and in no way augur disaster for the issuer, but as we said in the introduction, there are so many alternatives at comparable rates on the bond market, whose trend is more stable or better, whose sector is less cyclical and less linked to a fad or a game success, or whose possible stumbling blocks on analysis are fewer, that it would be a shame not to make the arbitrage.

1. A balance sheet that has deteriorated significantly since 2019 with :
   1. Stable cash flow
   2. debt doubled
   3. sales up by only a third

This means that the debt incurred has not been allocated to sales- or cash-flow-generating investments, but has for the time being only been spent. Generally speaking, in such cases, this excess debt is found in intangible assets, enabling a company to keep its asset/liability ratio stable and make cheap promises to investors.

1. This is precisely what we’re seeing at Ubisoft, where intangible assets have risen from 70% of the balance sheet in 2019 to 92% today. The problem with intangible assets for a creditor is twofold: firstly, they are difficult to value, unlike an inventory of goods or a movable or immovable asset; secondly, they are often much more dependent on a company than a tangible asset, and we have observed empirically that they often lose most of their value when the company is doing badly, a fortiori during a default or debt restructuring. In a “stress test” type analysis, by devaluing intangible assets by 50%, which is not an extreme case in phases of restructuring or urgent disposal, Ubisoft’s Debt/Asset ratio would therefore move into the scarlet red. More to the point, the net debt/Ebitda ratio can only be assessed dynamically insofar as the company’s ability to generate revenues from its assets can be correctly assessed by the analyst. When 90% of these assets are intangible, this exercise becomes particularly complicated.
2. Extremely volatile results and cash flows: much like the fashion or art production sectors, the video game industry is relatively dependent on game launches, with trends in fashion, Momentum, artistic and technical success. In past years, Ubisoft managed to offset this operational and cash flow volatility with a prudent financial policy and a very solid balance sheet. More recently, more risky investments or a surfeit of volatility and disappointments to absorb have significantly damaged the balance sheet, which we believe will no longer have sufficient absorption capacity for a creditor. Let’s be clear, ‘for a creditor’, because his potential return is capped, whereas his potential loss is total, whereas a shareholder might hope for a blockbuster game, for example, capable of bouncing the stock back to its peaks. The creditor would see no benefit other than being repaid, as with a less risky issuer.
3. A decline in the ability to pay down debt: current indebtedness and past cash flows could be considered of relative importance if the episode is over, capital flight contained and the outlook brighter. This is not the case at Ubisoft, where cash flow prospects for the coming years seem to be falling sharply: free cash flow could thus drop from €500M to €600M per year between 2017 and today, to around €150M for the coming years… even though debt has doubled, creating a significant scissors effect. What’s more, the fall in cash flow is largely linked to a sharp increase in capex, which is expected to rise from around €100 million in recent years to €1 billion for at least the next two years… This will probably further increase debt and intangible assets before any beneficial effects. These figures show a very limited room for manoeuvre for the company, which could be offset by the unfailing reliability of management and solid governance, as may have been the case with companies such as Aryzta or Tullow in their recent history.
4. This has not been the case at Ubisoft for several years, for two reasons:
   1. The company has proved very unreliable in its outlook and earnings releases over the last few years, with numerous postponements of its return to profitability and several relative failures of its game launches, which could lead us to fear that it will go off course, given the current very narrow margin for manoeuvre.
   2. Governance is often singled out for criticism, with family quasi-monopolies within management, generational gaps, unclear reorganization and shareholder tensions…

All these factors are not ends in themselves, and in no way preclude a bond investment, provided the yield is sufficiently rewarding. This is clearly not the case for Ubisoft at the beginning of September, since at the date of our sale (09/09/2024) its 2027 bonds were offering a yield of 5.10% and the 2031 convertible bonds were offering a yield of 6.50%. Although the yield has since diverged, reaching a level of 7.75% for the 2028 bond at the time of publication (09/13/2024), this level still seems to us to lag well behind the issuer’s credit deterioration, which seems to us to be closer to a yield level of around 10%. Thus, the trend begun a few days ago is unlikely to be reversed, and it is still preferable to sell positions at current levels.