Keywords Studios — Looking like a winner as the dust settles

At its core, Keywords offers investors exposure to the growth of the video games market (primarily PC and console games), without taking on the risk of developing and nurturing IP and the commensurate success or failure of individual game titles.

In our view, the key attraction of Keywords’ investment case is that, as the ‘go to’ global games services platform, the company can continue to generate double-digit organic earnings growth for the foreseeable future based on underlying industry growth, actively supplemented by M&A in a highly fragmented market, without needing to expand beyond its targeted customer base in the games industry. This proven and consistent strategy has delivered a five-year revenue CAGR of 45% and an estimated EPS CAGR of 38% in FY15–20e.

Management is clear that Keywords’ successful model has a lot further to run, with investment from FY19 and FY20 set to support sustained growth over the course of FY21 and beyond.

At its capital markets days in November 2019 and February 2020, management focused on the benefits that increasing scale brought to the group, as well as the benefits of cross-selling across service lines. Management was also very clear that future M&A activity would focus on higher value-added service lines, including games development and marketing services (we expect marketing services will be separated out from art services in FY21).

After COVID-19 struck, H120 was focused on mitigating the impact of the pandemic and reorganising the business to enable effective remote working, with significantly stronger operational performance in H220. As economies gradually emerge from the pandemic, with market conditions expected to improve further, the company should be in a position to re-focus on the strategic goals outlined in early 2020, namely:

With the important caveat, that the COVID-19 pandemic does not worsen significantly from where we stand today, the medium-term growth prospects remain intact. Keywords is likely to benefit from increased development budgets for the new console generation (launched in Q420) as well as increasing new releases, expected in FY21–23, as the user base for the new generation of consoles builds over the next few years. Newzoo forecasts market growth for FY20–23 of 8% which, in our opinion, is likely to be a conservative figure following the exceptional 20% y-o-y growth estimated for FY20. From our perspective, it is hard to see why FY21 growth would slow so markedly from FY20.

Having initially lowered our estimates at the start of the pandemic and subsequently raised them three times, Keywords’ FY20 preliminary results were marginally ahead of our revised forecasts, driven by management’s effective response to the personnel and operational challenges of COVID-19, good cost control and unexpectedly strong underlying organic revenue growth of 12%. For FY21, we assume strong demand for Keywords’ services, with clients seeking to mitigate the impact of COVID-19 related project delays. We forecast like-for-like organic growth of 12% in both FY21 and FY22 (FY20: 12%) and 10% in FY23, in line with management guidance.

At the start of FY20, management had initially been confident that normalised PBT margins would build towards historical norms (c 15%) in FY20. However, COVID-19 disrupted progress and delayed normalisation by 12 months. Keywords reported a provisional H220 PBT margin of 15.7% (12.5% in H120), suggesting that, even allowing for a more normal cost base in FY21,15% margins should be achievable. Nevertheless, we have retained our PBT margin of 14.6% for FY21, rising slightly to 14.8% in FY22.

Keywords committed up to €92m for seven acquisitions in FY20 and is targeting six to 10 deals annually, through the cycle. With net cash of €101m as at 30 June 2020 (and guided net cash of about €100m as at 31 December 2020), together with €100m of undrawn debt facilities, the company retains considerable firepower for M&A activity in FY21 and beyond. Management continues to review a healthy acquisition pipeline and expects to complete further acquisitions in FY21 and FY22, with an emphasis on game development and marketing services as Keywords continues to move up the value chain, offering higher value-added services and extending its geographical reach. However, the timing of future acquisitions is likely to remain opportunistic.

Although our base case estimates do not reflect any contribution from future M&A, our sensitivity analysis in Exhibits 19 and 20 suggests that if management retains historical price discipline (ie paying 7–11x PBT for acquisitions) and deploys €50m in cash (plus equity) in each of 2021 and 2022, then FY22 P/E multiples could potentially fall to c 27–31x, based on our assumptions.

Other than the availability of M&A targets at attractive multiples, other key sensitivities that would have an impact on Keywords include a change in market sentiment towards high-growth technology stocks, a slowdown in the growth of the global games industry post COVID-19, the continuation of the industry trend towards outsourcing, the retention of key management, Keywords’ equity remaining an attractive acquisition currency, stable foreign exchange rates relative to the euro and the continuation of a benign interest rate environment.

Keywords benefits from the trend towards outsourcing, increasing market share as a leader in a fragmented global industry, with growth further supplemented by a proven M&A model. Clients tend to share their title roster with Keywords 12 months ahead of release for resource planning purposes, giving Keywords a unique view of the forward pipeline of work in 2021 and beyond. Where games that Keywords is working on are delayed, this will usually mean an extended project for Keywords, with the probability of extra work and additional income.

As we start FY21, growth drivers for the short, medium and long term all look positive. Continued industry development spending to meet heightened consumer demand and the increasing trend towards outsourcing supports the short-term outlook, with medium-term growth boosted by a strong pipeline of new launches on next-gen consoles in FY21–23. Long-term demand is underpinned by strong secular and technology trends as gaming increasingly penetrates remaining age brackets and, with increasingly diverse and affordable technology (mobile, PC, console, streaming, 5G, e-sports, VR), all remaining geographies.

Keywords’ shares trade on an FY21e P/E of 38.9x, falling to 34.5x in FY22e, in line with its UK games industry peers. Although this is a demanding valuation, we expect the recent next-gen console launches to lead to a period of heightened game releases, benefiting underlying growth in the period from FY21–23. When complemented by Keywords’ proven accretive buy-and-build strategy, this should further reduce valuation multiples.

Keywords is the largest and most diverse supplier of outsourced services to the games industry by some margin. Through consolidation of a fragmented industry landscape, the company has built a breadth of service offering covering most of the games development cycle, from the original conceptual phase through to customer support, managed through seven service lines (Exhibit 1).

Keywords is building a global footprint (with over 8,000 staff across 60 studios in 21 countries) to ensure its service hubs are located close to the end client.

The company started its build-out strategy by acquiring positions in domains such as localisation, localisation testing, functional testing and audio services, all of which are vital ancillary functions in the game development cycle. Keywords continues to strengthen its position in these service lines, largely through acquiring companies that extend the group’s geographical footprint.

More recently, the company has intensified its acquisition activity in domains that are closer to the core games creation process, building out its game development and co-development offering and strengthening its position in marketing services.

As well as continuing to augment its current service offering (particularly in game development, audio services and marketing) and in-fill acquisitions (Asia and the Americas), we expect Keywords to position itself to benefit from future trends including e-sports, games-as-a-service (GaaS) and streaming, as well as investing in developing analytics and AI capabilities.

Keywords is the largest supplier of outsourced services to the global video games industry. By consolidating a highly fragmented industry landscape, the group continues to build a unique portfolio of services that spans the breadth of the games development cycle, from original concept through to go-live and post-launch support. Based on H120 revenues, the group now has a good balance across its seven service lines, with an investment bias towards higher-margin areas including game development and marketing services.

Keywords has a presence in most of the major games development hubs globally and provides services to many of the major games companies (PC, console and mobile) worldwide.

The games industry’s shift away from hit-or-miss one-off product launches to a more predictable, recurring, franchise-based GaaS model lends itself to retained multi-year, multi-service engagements for Keywords. Keywords is progressively developing strategic, multi-service relationships with most major publishers.

Despite a progression towards higher-margin projects, Keywords continues to avoid revenue share fee arrangements. The Keywords model is built on a cost-plus approach, with services paid for on a time and materials basis. In this way, management can ensure that Keywords’ cost base is covered and avoids the risk of cost-overruns on fixed-price contracts.

The video game sector has established itself as a mass-market media format, estimated to be worth more than US$175bn globally in FY20, with year-on-year growth of 20% in FY19–20 and forecast growth of c 8% between FY20 and FY23 (source: Newzoo).

Against this background of strong and continuing sector growth, Keywords delivered underlying organic revenue growth of 12% in FY20 (H120: 8.0%, FY19: 15.5%), a hugely resilient performance given the headwinds from COVID-19.

Management expectations are for Keywords to deliver sustainable revenue growth of 10% in the medium to long term, with the key elements of growth breaking down as follows:

Management anticipates that acquisitions would then supplement this organic growth.

As game complexity increases, there is a continuing trend towards outsourcing to manage the risk and cost of the large peak team sizes required to create market-leading titles. This complexity has only increased for the new generation of games consoles. Consequently, we expect the market for outsourcing (estimated by Keywords in its FY19 results to be worth c US$6.5bn+) to grow more rapidly than the overall games market (we estimate c 10%) as developers increasingly refocus on their core development discipline, outsourcing peripheral functions in order to improve flexibility.

Keywords’ active M&A strategy is supported by the fragmented competitive landscape for service providers to the games industry. Keywords does not need to compete for the highly sought after studios that have developed and own successful IP (eg Embracer/Gearbox , mtg/Hutch, EA/Codemasters), but rather targets reliable service providers that work with these leading games studios. This enables Keywords to continue to acquire studios at attractive multiples even while valuations for leading development studios achieve ever higher levels.

To validate Keywords’ success at cross-selling, management tracks the number of clients that take three or more of Keywords’ services (Exhibit 5). This number has broadly doubled since FY16, with numbers growing at c 20% pa. As has been seen since the acquisition of VMC in 2017 (Keywords’ largest single deal at US$66m), large clients are seeking to work with a counterpart at scale. Keywords has increasingly been recognised by major US clients as having the scale they are looking for in a partner, able to offer a professional level of service to studios around the world.

As an example of active cross-selling, US-based AAA developer Gearbox Software (bought by Embracer Group in February 2021) has a longstanding outsourcing relationship with Liquid Development, a Keywords studio. When Gearbox needed to rapidly scale-up art production ahead of the launch of Borderlands 3, it turned to Liquid Development, which in turn was able to draw on the resources of two of Keywords’ other studios, Mindwalk Studios (Beijing, China) and Lakshya Digital (Pune, India), to offer a rolling 24-hour development solution to help Gearbox create Borderlands 3, one of 2019’s most popular games.

By leveraging its relationships with Keywords’ art services studios in Asia, Liquid Development created a scalable, cost-effective managed outsourcing infrastructure that Gearbox trusted to hit its critical release timelines. Working with Keywords, Gearbox has now completed four critically acclaimed Borderlands releases, including DLC and special editions.

In FY19, Keywords invested in its platform and capacity to ensure that it could deliver a full suite of services, with a similar level of professionalism, to clients wherever they are based, with services fronted by a local team, but deliverable on a round-the-clock, distributed basis to meet client needs. Investment continued in FY20, but was more focused on ensuring resilience in the face of COVID-19, than immediate expansion.

Management identifies the following benefits and barriers from increased scale:

Keywords’ business is managed across seven service lines, reviewed at a high level below.

As we have discussed in previous notes, QA/testing and audio services have been the service lines most affected by COVID-19. Audio services struggled in H120 due to its reliance on recording studios, which were forced to close, while testing is part of the final polishing of a game just before release. Understandably, clients were initially hesitant to allow sensitive, pre-release titles to be subject to remote-working protocols whereby Keywords’ employees would have open access from their home office.

Art services, player support and functionality quality assurance (QA) were less affected by COVID-19 in H120, while game development experienced a boom in demand, although management does not believe that growth will be sustainable at these levels in FY21. Having successfully managed the transition to remote working in H120 (with 8% organic revenue growth), management believes that it has workable solutions in place for most clients across all business lines, with average organic growth picking up to c 15% in H220 to deliver average organic growth in FY20 of 12%.

Management is understandably targeting acquisitions in the higher-margin game development and marketing services business lines, which have shown the strongest organic growth (Exhibit 9).

Market analyst Newzoo estimates that more than 2.2 billion gamers have generated global revenues of c US$175bn in 2020, with European and North American markets representing c 45% of global revenues and Asia-Pacific (dominated by China) representing 48% of total revenues. 49% of global revenues were on mobile devices, with 29% on console, which showed exceptional year-on-year growth of 21%. Overall revenues are forecast to grow at c 8% (2020–23), building to a total market size of over US$218bn by 2023. Mobile is forecast to offer continuing double-digit revenue CAGR from FY20–23, with console estimated to offer high single-digit growth and PC low single-digit growth to 2023 (Exhibit 12).

On top of the games industry’s growth of c 8%, we believe the market for outsourced services could grow at a premium, driven by increased use of outsourcing. Given these dynamics, Keywords remains well placed to consolidate its market position, both organically – as business is attracted to the market leader, with a global international footprint matching its international clients – and through further acquisitions, as the company consolidates an over-fragmented landscape.

As we have highlighted, we see Keywords’ future growth coming from three principal sources:

Sizing the market for outsourced services is difficult, but alongside its FY19 results, Keywords’ management estimated that total spend on the services it offers was conservatively c US$6.5bn pa, of which 35–40% was outsourced (Exhibit 15). We would highlight that this number appears conservative in the context of Newzoo’s estimate of US$175bn of industry revenues (ex-hardware) in 2020. If we ignore Chinese revenues of c US$44bn, global revenues (ex-China) are c US$130bn. We would assume 10–20% of revenues are spent on development, implying a total addressable market (TAM) of US$13–26bn, although only a proportion of this will ever be outsourced.

The degree to which outsourcing has been adopted varies across service lines, but management estimates that, on a blended basis, this percentage will trend upwards towards 70% over the next five years (a comparable figure for the film industry might be close to 90%). This would imply an outsourcing CAGR of 10%+ over the next five years (on top of industry growth), or conservatively, 15–20%.

The trend towards outsourcing is likely to be supported by a number of specific factors:

Future M&A, although opportunistic, is likely to be concentrated on higher-margin business lines, with management highlighting games development and marketing services in particular. Opportunistic M&A in other service lines will also be considered, with Keywords’ largest acquisition to date, VMC for US$66m in 2017 (which offered localisation and QA at scale in North America), a possible model for expansion in Europe, India and Asia.

In terms of approach, Keywords conducts its own due diligence, avoids auctions and has maintained rigorous price discipline to date (we estimate recent deals at 1.5–2.0x sales and a long-term average ~1.2x revenue multiple). These low multiples are achievable because Keywords tends not to compete with other buyers; developers and publishers normally look to acquire IP and content, whereas Keywords is primarily seeking service competence and is not interested in IP.

Since its IPO in 2013, Keywords has attempted to build a reputation as an attractive acquirer. It focuses on cultural fit as an important screening criterion, with businesses retaining their identity and a degree of strategic autonomy, while benefiting from the group’s central systems and financial stability. Management reports continuing inbound interest from companies from around the world, but remains disciplined to ensure it does not overpay.

Keywords has been the main visible driver of consolidation within the games service provider space. The group targets six to 10 deals annually, through the cycle, including one or two larger strategic acquisitions each year. Since IPO, we estimate that Keywords has completed c €340m in deals (Exhibit 16), an average of almost €50m a year, with a maximum annual spend of €101m in 2017. The average deal size since IPO has been a little over €6m. In 2020, Keywords completed seven acquisitions, for a combined consideration of up to €92m, an average deal size of €13m.

The markets in which Keywords operates are highly fragmented and remain ripe for consolidation. Most service providers are sub-scale, with revenues dependent on a small number of customers and limited exit options.

Across Keywords’ service offering, we believe there is scope to continue building its platform and for the buy-and-build strategy to deliver sustained returns. Although recent acquisitions have put Keywords in a leadership position in some service lines – such as Audio Services, Localisation and Localisation testing in certain markets – the addition of service lines such as Art Creation, Game Development and Player Support open up substantially larger markets.

With net cash of €101m as at 30 June 2020 (and company guided net cash of about €100m as at 31 December 2020 despite c €36m in H220 acquisition spending), together with €100m of undrawn facilities, the company retains considerable firepower for acquisitions in FY21 and beyond. The acquisition pipeline remains healthy and management continues to review opportunities that could add critical mass, increased capacity and extend the group’s service offering or geographical reach.

We believe that Keywords’ attributes as the market leading games service provider will not be easy to replicate, but nevertheless, we watch for competitors building international scale or increased competition for key acquisition targets. We see sporadic acquisition activity but, as yet, no competitor has become apparent that is able to operate at a similar scale to Keywords.

Sumo Digital, a UK-based provider of outsourced creative and development services to the video games industry, which listed on AIM in December 2017, is steadily migrating away from the work-for-hire model towards IP ownership. Catalis, a European publisher (Curve Digital) and testing business (Testronic), preferred to stay private rather than listing in 2019, selling to a private equity buyer, NorthEdge, for £89.8m (2.2x FY18 sales, 18x FY18 P/E). However, we would not rule out an IPO of the business in 2021. ZOO Digital, a provider of cloud software-based subtitling, dubbing and media localisation services to the TV and movie industry, has not been acquisitive historically, but with increasing overlap between games and media, its interest in games is building.

It is possible that outsourcers from outside the games industry may look to expand into games through acquisitions (eg Lionbridge), but we have yet to see any significant moves of this kind, and getting traction in the games sector may be challenging for non-games companies.

Once an acquisition has been completed, management’s key focus is on integrating central functions and normalising margins to group levels as quickly and efficiently as possible. Most acquisitions are expected to achieve group-level PBT margins (c 15%) within two years.

Keywords targets a 15–30% return on investment (ROI) from acquisitions within two to three years, through maintaining good price discipline. Historically, valuations have averaged c 1.2x sales, with average EV/PBT multiples of 7–11x. Keywords occasionally pays higher multiples for larger strategic acquisitions, but with the intention that multiples will still fall within this range once acquiree margins normalise to the group’s 15%+ level.

In the long term, management wants to enable new studios to leverage Keywords’ platform to allow them to significantly increase scale through cross-selling, international expansion and the acquisition of new customers.

In FY20, we initially downgraded our forecast in April, before upgrading our numbers three times over the course of the year as Keywords’ operating resilience became clearer. Despite this, Keywords’ FY20 preliminary results were marginally ahead of our forecasts. This was driven by management’s effective response to the personnel and operational challenges of COVID-19, good cost control and unexpectedly strong underlying organic revenue growth of 12%.

As we start FY21, growth drivers for the short, medium and long term all look positive. Continued development spending to meet heightened consumer demand and the increasing trend towards outsourcing supports the short-term outlook, with medium-term growth boosted by a strong pipeline of new launches in FY21–23 on next-gen consoles. Long-term demand is underpinned by strong secular and technology trends as gaming increasingly penetrates all remaining age brackets and, with increasingly diverse and affordable technology (mobile, PC, console, streaming, 5G, esports, VR), all remaining geographies.

Our underlying FY21 forecasts remain unchanged, assuming strong demand for Keywords’ services, with clients seeking to mitigate the impact of COVID-19-related project delays. We forecast like-for-like organic growth of 12% in both FY21 and FY22 (FY20:12%), before growth returns to management’s long-term guidance of 10% in FY23.

Initially, at the start of FY20, management had been confident that normalised PBT margins were building towards historical norms (c 15%) in FY20. However, COVID-19 disrupted progress and delayed normalisation by 12 months. Keywords reported a provisional H220 PBT margin of 15.7% (12.5% in H120), suggesting that 15% margins should be achievable in FY21 even with a more normal cost base allowing for travel, events and marketing. Nevertheless, we have retained our PBT margin of 14.6%, rising slightly to 14.8% in FY22.

Based on our estimates for FY20, Keywords has recorded a five-year revenue CAGR for FY15–20 of 45% and a five-year EPS CAGR for FY15–20 of 37%. Looking ahead, pre-M&A, we are forecasting a revenue CAGR of 18% for FY20–22 and an EPS CAGR of 15% for FY20–22.

Key estimates are set out in Exhibit 17 below.

Keywords’ shares trade on an FY21e P/E of 38.9x, falling to 34.5x in FY22e, in line with its UK and European games industry peers. Although this is a demanding valuation, we expect the recent next-gen console launches to lead to a period of heightened game releases, benefiting underlying growth in the period from FY21–23. Supplemented by its proven buy-and-build strategy, we expect Keywords’ earnings to be supported by new deals, potentially further lowering valuation multiples.

Establishing a peer group for valuation purposes is difficult. Although Keywords operates in the games industry, it provides support services to the industry and therefore has a different business model from mainstream developers/publishers. However, as it enjoys the growth of the games industry, these companies (and their global peers) are likely to remain the companies to which it is most frequently compared.

As can be seen in Exhibit 18, Keywords’ valuation ties in closely with the UK peer group, both in terms of EV/EBITDA and P/E multiples. This is despite Keywords’ market leadership, international reach, track record and superior growth potential. In contrast to the UK games companies, Keywords successfully operates a buy-and-build model that should supplement earnings and support growth over the FY21/22 forecast period.

Looking at the broader international peer group, valuations are both lower and more mixed, with an average FY1 P/E multiple of 27.0x and an FY2 P/E multiple of 25.4x vs 46.5x and 34.4x respectively in the UK. The larger and more mature US peers trade on notably lower multiples (eg Activision Blizzard, Electronic Arts), reflecting mature business models and slower growth. However, other European games companies operating digital models (eg Paradox, Remedy) trade on similar multiples to the UK games companies. We would also highlight Embracer Group, Stillfront and Media and Games Invest (MGI), all of which are listed in Stockholm and follow an active M&A strategy. These trade on FY1 EV/EBITDA multiples of 12–22x versus 26–33x for the UK peers, with Keywords trading on 28.2x FY1 EV/EBITDA.

Although our base case estimates do not reflect any material contribution from M&A, our sensitivity analysis in Exhibits 19 and 20 suggests that if management retains historical price discipline (ie paying 7–11x PBT for acquisitions) and deploys at least €50m in cash (plus equity, assuming a 70/30 cash/equity split) in acquisitions in each of FY21 and FY22, it is reasonable to expect 7–20% accretion to our FY21 EPS estimate and 11–28% accretion to our FY22 EPS estimate. With good execution and all other things being equal, the FY22 P/E multiple could therefore fall to c 27–31x, far less demanding given the group’s continuing growth prospects.

With company guided net cash of about €100m as at 31 December 2020 (despite significant H220 acquisition spending), together with €100m of undrawn facilities, Keywords retains ample firepower for this level of acquisitions in FY21 and beyond.

It is difficult to see any one factor that would significantly compromise Keywords’ progress, although setbacks could significantly dent the share price.

Acquisitions: Keywords’ strategy and track record of making earnings-enhancing acquisitions and providing a platform for these businesses to perform well is key to the investment case.

Technology sector valuations: investors have been willing to attribute high valuations to companies in the technology and games sectors during the COVID-19 pandemic for their strong defensive growth prospects. A rotation away from growth to value might lead to a re-rating of Keywords’ equity.

Scale/rating: pressure on management to pursue a more aggressive strategy could increase as the size of company required to ‘move the needle’ rises or multiples re-rate upwards.

Games industry growth: the games industry has been enjoying strong structural growth for a number of years. We believe that structural growth is set to continue for the foreseeable future (Newzoo forecasts growth of c 8% pa to 2023).

Foreign exchange risk: Keywords operates a number of offices around the world and generates revenues in multiple currencies, and it is therefore exposed to exchange rate risk.

Key person exposure: as it has grown, Keywords has strengthened its senior management team, appointing Jon Hauck as CFO (ex Rentokil) in 2019 and Sonia Lashand Sedler as COO (digital transformation specialist, ex Diebold Nixdorf) in 2021. Nevertheless, Keywords’ performance could be affected by the loss of key management, particularly Andrew Day, CEO.