Stockholm Syndrome: the short story of Embracer Group 

James Corkin recounts the story of a recent successful short position in a high-flying gaming company, and how numerous accounting red flags should have been a warning to the company’s devoted supporters ahead of a major stock price collapse.

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The term ‘Stockholm Syndrome’ was coined in 1973, in the wake of the bungled heist of one of Stockholm’s largest banks, Kreditbanken, by would-be bank robber Jan-Erik Olsson. During the ordeal, Olsson held four bank employees hostage in the vault for six days. But when the hostages were finally freed, and Olsson apprehended, there came a very unexpected twist. The hostages refused to testify against Olsson, refused to cooperate with the police and even began raising money to fund their erstwhile captor’s defence! The drama sparked widespread interest and culminated in the term “Stockholm Syndrome” to describe the psychological phenomenon where hostages develop empathy for their captors. Unfortunately for Olsson, despite his former hostages’ best efforts, he ended up back in prison.

Stockholm Syndrome is alive and well in financial markets too. A wonderful illustration of this is the story of our recent successful short in Embracer Group AB, a former high-flying PC and mobile gaming roll-up – which, coincidentally, is also listed in Stockholm.  

Our analysis had led us to short the company after we discovered a veritable smorgasbord of accounting shenanigans, not to mention debt and cash flow issues at the company. However, when a prominent publication raised valid questions about Embracer’s unorthodox accounting, many investors and sell-side analysts jumped publicly to its defence. Sell-side analysts claimed that the critics “simply didn’t understand the business model”, while other institutional investors labelled the criticism “click-bait”. Despite their protests, as with Jan-Erik Olsson some 50 years prior, Embracer’s day of reckoning arrived in mid-May, when a disappointing trading update triggered a 60% share price collapse in short order.  

Below we outline some of the key red flags that piqued our interest.

Beware roll-ups (not rollmops)…

Serial acquirors, or “roll-ups”, have produced some spectacular blow-ups (and frauds) in recent history. Valiant Pharmaceuticals, Tyco and EOH were all serial acquirers. Acquisition accounting allows significant opportunity to play accounting games – by shifting revenues or costs to pre- or post-acquisition periods, capitalising assets into Goodwill (which isn’t amortised), creating bogus acquisition reserves and even boosting operating cash flows. Furthermore, companies that constantly acquire other businesses can be fiendishly difficult (often intentionally) to disaggregate into organic and inorganic performance, making it easy to disguise deteriorating organic business performance. Embracer, a company consisting of over 120 distinct gaming studios, most of which were acquired, made no less than 60 business acquisitions in the 2022 financial year alone! But the frenetic M&A belied the fact that in the 9 months to December, organic revenue was going backwards and margins were declining.  

…and management’s alternative measurements

Portrait of James Corkin, Portfolio Manager at Steyn Capital Management
James Corkin, Portfolio Manager at Steyn Capital Management

Most strikingly, Embracer’s preferred “Adjusted EBIT” reflected a very different picture to the EBIT from the financial statements. In 2022, Embracer reported an EBIT loss of SEK 1.2bn, while simultaneously reporting a management “Adjusted EBIT” profit of SEK 4.5bn. In fact, over the 12 quarters to March 2023, Embracer’s cumulative reported EBIT of SEK 1.1bn paled in comparison to the SEK 13.7bn in “Adjusted EBIT” presented by management. Among some of the more outrageous management adjustments to earnings was an adjustment to add back certain personnel costs related to acquired businesses, transaction costs (a recurring expense for a serial acquiror) as well as the amortisation of the hilariously named “surplus” intangibles recognised on acquisition (i.e., how to say you overpaid without saying so). 

Furthermore, over the same period, the company capitalized over SEK 8bn of expenses, which had been ballooning at a rate well-above revenue growth. While capitalizing development expenses is to be expected in the software business, this is an area fraught with subjectivity, and in Embracer’s case over a twelve-quarter period the capitalization exceeded operating profit by a factor of 7!  

The company’s creativity didn’t stop at adjusted earnings. Management’s reported net debt also excluded the future payments due on its many acquisitions, a material balance for an acquisition-fuelled business paying a significant portion of the cost price in future periods (while of course bringing in 100% of earnings from the year of acquisition). Adding these legitimate liabilities to net debt more than doubled its reported net debt, which all of a sudden jumped to 4.4x its EBITDA (real EBITDA, that is) compared to the management reported 1.2x. 

Despite these issues and others, the company’s market cap when we initiated the short was over US$7bn (SEK 76bn). On our numbers, this translated into an eye-watering valuation of 218x EV/EBIT.     

Cash is king – right?

Defenders of the company might have pointed to the optically high operating cash flow of the business – which over the preceding 12 quarters came in at a rather robust-looking SEK 13.2bn. Unfortunately for them, they would have overlooked the rather technical, but crucial accounting fact that highly acquisitive companies naturally have artificially inflated operating cash flows. This is because they record the acquisition of acquiree working capital balances in the investing cash flows section of the cash flow statement, while recognising the unwinding of them in the operating section of the cash flow statement, without any of the costs normally incurred in generating that cash. This is a simple and one-time accounting phenomenon which occurs before any sleight of hand is used to, say, shift operating cash to the investment section – which in Embracer’s case might have included classifying actual working capital cash outflows (like IP catalogues) as “asset deals” to amplify the above effect. This trick was one that Tyco, an infamous accounting fraud, used to great effect in the early 2000’s.  

In simple terms, operating cash is not a good yardstick for a business that makes 60 acquisitions in a single year. A far better measure is free cash flow after acquisitions. In Embracer’s case this told a very different story with the free cash flow over the same 12 quarters totalling a staggering negative SEK 46bn.

But wait there’s more 

The list goes on – from missing disclosures the company deemed “too onerous” to disclose, to restructures and changing accounting policies – this is a company with some issues. For all the more technical issues – perhaps the most obvious is that the company’s balance sheet consists almost entirely of amorphous acquisition-created Goodwill and intangible assets, and significant debt, with little to no cash flow generation.   

Where to now? 

Following its disastrous May update, Embracer has embarked on a major restructuring program and intriguingly has also decided to change its auditors. Despite the substantial pain to date, the company still commands a market cap of US$3 bn and has no shortage of advocates who have drunk the kool-aid. While the final chapter is still to be written for Embracer, the story appears to share more than a few similarities with the Kreditbanken saga of 50 years ago, and we continue to follow it with keen interest.


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