Square Enix didn’t know how to squeeze profits out of its western studios

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Square Enix is washing its hands of its biggest western studios. The company announced it is selling Eidos and Crystal Dynamics to Embracer Group. This raises numerous questions about what is happening next with Square Enix, but first let’s focus on the why. Why did Square Enix drop the Tomb Raider and Deux Ex studios? And why for the seemingly low price of $300 million?

The bottom-line reasoning for this move is profitability. Square Enix has spent a lot of money on these studios, but it hasn’t figured out how to make income from that investment. In 2021, Eidos Interactive generated its highest revenue in three years. But those revenues did not offset its costs — Eidos had a profit margin of 0.65%. During that same period, Crystal Dynamics also had its highest revenue but generated a profit margin of just 3.6%.

“Square Enix as a whole had an operating income margin of 14.2% last year,” Niko Partners analyst Daniel Ahmad wrote on Twitter.

Square Enix clearly ran out of ideas

Companies hate to carry around a drag on their profitability, but that doesn’t mean they instantly sell off underperforming business units. Square Enix had the choice of figuring out what to do next with Crystal Dynamics and Eidos. But this deal suggests that Square Enix ran out of ideas.

The publisher already went from having Crystal Dynamics and Eidos working on their own IP to working on Disney’s major Marvel brand. The cost of that license almost certainly contributed to the low profitability of the studios. But more than that, you get the sense that Square Enix is saying, “If Marvel couldn’t make these studios profitable, nothing can.”

As I reported around the time of release, Eidos’s Guardians of the Galaxy seriously underperformed. It sold less than 1.5 million copies in its first couple of months even after multiple discounts at retail.

If we look to competing publishers, we can see that Square Enix had other — not great — options.

EA has repeatedly shut down any project that doesn’t have at least a projected profit margin of 15%. This has left the studio with fewer and fewer projects each year, though.

Activision has taken a similar tact to EA, but instead of closing down studios, it has simply put all of its teams into the Call of Duty or Blizzard content farms. Square Enix has already experimented with this. It made a deal to let Crystal Dynamics work with Microsoft’s The Initiative on Perfect Dark.

Why so low?

The low profitability of Crystal Dynamics and Eidos pushes down their value. Embracer would get a better return on its money by simply putting $300 million into an index fund. At least if the studios continue on a similar trajectory to 2021.

But both companies know that the studios will likely produce better net income when working on their own IP. Eidos had a profit margin of 7.2% in 2019, for example. And the IPs themselves have value.

So even when you factor in the cost of operating a studio, Embracer is getting a lot for a fairly low price. That suggests that Square Enix either has completely new business strategy or other motivations.

Square Enix has already alleged that it wants to invest more in blockchain, AI, and cloud gaming. And it probably will do that. Crystal Dynamics and Eidos likely had no interest or skills in those areas. So the publisher is pursuing a future that had no use of those teams.

But it’s also worth recognizing the context in which this deal is happening. Massive conglomerates like Microsoft are purchasing giant publishers like Activision. Tencent is still looking to make acquisitions. Sony PlayStation has indicated it wishes to continue to make moves. And every other publisher is trying to position themselves to get acquired, to merge, or to acquire something else themselves.

By dropping its underperforming studios, Square Enix makes itself more streamlined for potential acquisition. And maybe that is the next part of this story.

Originally appeared on: TheSpuzz