Keywords Studios — Strengthening position in an attractive market

Keywords has established a strong leadership in a games industry where growth has accelerated to a double-digit rate. Driven by increased outsourcing, the market for services providers in this industry should grow more rapidly than this and Keywords has the potential to grow more rapidly again, driven by market share gains and cross-selling. The group’s diversity across customers, geographies, games formats and service lines means it has a demonstrable ability to ride out the inevitable volatility, which regularly occurs in individual elements of this high growth, dynamic market.

To set the overall context, the games industry continues to go from strength to strength. Market analyst Newzoo recently upgraded its 2017–21 growth forecast for the games industry to 10.3% from 7.4% previously, estimating that 2.3 billion gamers across the globe will spend $137.9bn on games in 2018. It estimates that if all playing and viewing hours are added up, gaming is the world’s favourite pastime.

The pace of change and innovation far exceeds any other consumer media. The mobile gaming market has grown in 10 years from a nascent, pre-smartphone industry to one worth $70bn. The eSports market has growth from below $100m in 2011 to an estimated $700m in 2017, and is expected to reach more than $2bn by 2023.

Keywords estimates that the total market for services in this industry is worth c $6bn, of which around 50% is currently outsourced. Over time management believes that the industry may trend towards the TV or film models, where c 90% of production in outsourced. It is difficult to put a timescale on this trend, but if the overall industry sustains its 10% growth rate, we believe a mid-teens growth rate should be sustainable for the outsourced services market. (This would imply that 60% of all work is outsourced by 2021.) The accelerating rate of innovation and improving production values should also be supportive trends, in that they increase the direct cost of carrying out work in house in an inherently unpredictable industry. Management also comments that outsourcing decisions are increasingly being made at a strategic level as developers move away from vertically integrated structures, rather than in response to a capacity crunch. The company has not yet succeeded in converting its first strategic outsourcing deal (whereby a developer essentially outsources its development team to Keywords), but industry dynamics appear increasingly supportive and deal sizes could be significant ($10m+).

While the pace of development and innovation in the industry brings inevitable patches of volatility, Keywords has a demonstrable ability to ride these transitions relatively well, benefiting from the strength of its model and revenue diversity.

We are going through one of these patches now, with the phenomenal rise of Fortnite Battle Royale, which has attracted 125 million players within one year of release. This success has likely expanded the overall market by bringing in new players to gaming and is estimated to have generated several hundred million dollars of revenues for Epic Games, its developer. Total sales of the game are estimated to be over $1bn (Superdata). Equally, some of Epic’s competitors will have inevitably felt the squeeze and we are seeing some signs of increased volatility in the market. Whilst not necessarily attributable to Fortnite’s success; Telltale games, developer of The Walking Dead abruptly ceased operations in late September, having reportedly failed to secure funding. Furthermore, Capcom, best known for the Dead Rising franchise has closed its Vancouver operation and is refocusing on developing games for Japan.

We understand that Keywords had limited revenue exposure to Fortnite in H1, meaning that the game’s success was a moderate headwind as competitors scale back development activity and reassess their options. The group has since won more Fortnite business, which will support trading in H2, but the recent closures discussed above do add a level of uncertainty to the near-term outlook. It is also worth highlighting that the games release schedule is particularly congested for Q418, resulting in speculation that some high profile launches may be pushed back.

The games industry’s progression towards a recurring revenue model is expected to accelerate. Downloadable extensions and content have become important revenue generators for games publishers for some time. We are now seeing a more concerted shift towards a subscription pricing model, which some observers anticipate could have as fundamental an impact on the games industry as it did on the music industry.

Microsoft has taken a step in this direction by including the latest releases in the Xbox Game Pass and acquiring a number of development studios for exclusive rights on its latest titles, replicating Netflix’s strategy in video.

Established players like Microsoft, NVidia (with GRID), and EA and start-ups (eg Parsec, GameStream) are developing cloud gaming/streaming solutions, which will allow games to be played over the internet with no or minimal client-side software. Improvements to technology, which reduce latency issues, and adoption of higher bandwidth, should support the roll-out of increasingly sophisticated games via this delivery mechanism.

We see this as a positive development for Keywords. The company is already is already benefiting from publishers’ increasing reliance on downloadable extensions and content, where outsourced suppliers are often used. Keywords is already working on interactive streaming content and porting games to upcoming streaming platforms, and the work involved in repurposing content for this new medium could provide an attractive new revenue stream for some time.

Keywords has made 21 acquisitions since the start of 2017, deploying c £120m of capital and close to 4m shares in doing so. This M&A activity has materially expanded the company’s delivery, with the expansion of the group’s engineering and customer support from start-up positions to established service lines the most notable development.

In customer support, the priority with VMC, the company’s largest acquisition to-date ($66m in October 2017) has been on stabilising revenues and releasing cost synergies through both headcount reduction and office consolidation. Implementation of the integration and cost reduction programme has been more rapid than initially expected, and it is now largely complete. (Initial guidance was £2.5m of cost synergies over two years.) The focus for the operation is now on resetting the business on a growth trajectory, supported by cross-selling across the wider platform, although our initial forecast of achieving 5% y-o-y growth for VMC in 2018 may now look a touch optimistic.

In engineering, the M&A programme has grown the service line to 8% of revenue in H118 from a standing start in May 2017, with the acquisition of GameSim, followed by d3t and Sperasoft, in 2017. The run rate contribution will likely rise to the low-teens level with the acquisitions of Yokozuna Data, Snowed In, Studio Gobo and Electric Square since period end. We see a strong engineering capability as a key component in securing large, multidisciplinary contracts.

Announced with the results, the company acquired Trailer Farm (for £1m with a further £1m contingent on profit expansion), a Brighton, UK-based production company focused on creating trailers for the marketing and support of video games. This acquisition will complement the company’s recent Fire Without Smoke marketing services business.

The M&A programme means that Keywords now has a presence in most of the main service disciplines within the gaming supply chain, although with less than 5% of the total market, there remains plenty of scope for further consolidation. The market remains highly fragmented and Keywords is now the largest player by some margin. Management has highlighted art as a particular area of potential activity. It has focused on organic development of this service line in recent times following an acquisition spree in 2015/16 to establish the line, but now looks ready to resume acquisition activity.

While historical acquisition activity has focused on acquiring relatively small but established businesses, the company’s strong platform and greater scale are now supporting smaller transactions, whereby the company brings in teams or technology with little or no ongoing revenues, instead relying on the company’s sales platform to drive revenues and a return on investment.

Keywords’ ability to successfully acquire good businesses at attractive multiples and then generate sales or (less often) cost synergies is clearly key to the investment case. We see no evidence that this ability is waning. While the company has paid slightly higher multiples for some smaller businesses in recent times, this is averaged down by the lower multiples paid for larger ones. We were particularly encouraged by the acquisition of Gobo in August, where at a maximum 7.6x historical EBITDA, the group appears to be buying a good asset at a very reasonable multiple. While the trailing PBT multiple for VMC (the company’s largest acquisition to date) was higher than average (11.3x), this was a turnaround situation and cost synergies will bring this in line with the group’s 8–9x average within 12 months.

Interim results were as flagged at the trading update, with revenues growing by 72% to €110m and adjusted PBT growing by 67% to €16m. Like-for-like revenue growth was 8.6% on a constant currency basis, but the US$ weakness suppressed this to 2%. The drop in like-for-like growth rate from 17.2% for H117 can be attributed to a number of factors.

There remains some uncertainty in the market, particularly with the recent high profile closures of Capcom Vancouver and Telltale Games. While not specific to Keywords, we nudge down our FY revenue estimate by €3m to factor in the potential for headwinds faced by the sector in the short term. Nevertheless, we still expect a pick-up in like-for-like growth in H2. Keywords will have already traded through the peak season for the seasonal ancillary lines and will have good visibility on the projects to be delivered in the final quarter of the year. Returning VMC to growth will clearly help, while Studio Gobo (acquired in August and therefore not included in the H1 l-f-l figure) is also said to be trading strongly. The c 5% strengthening of the dollar versus the euro will also help headline numbers if rates remain similar from here (47% of FY17 revenues were US$ denominated, which will increase with the full-year contribution from VMC and Sperasoft).

Operating margins of 14.9% dropped from 15.6% in H2 last year, reflecting the muted sales performance and lower margins of VMC. A higher depreciation charge was also a factor, up by €1m to €2.47m, as a result of the VMC acquisition and facilities investment.

Our full year estimate implies a 15.9% operating margin in H2. Historically, H2 operating margins have been significantly higher in the seasonally stronger period (see Exhibit 7 and this year, H2 should benefit from the full period of cost savings at VMC and the contribution from Gobo (30% EBITDA margins pre-acquisition). This contrasts with an H217 in which operating margins absorbed VMC and still expanded by 40bp sequentially in H2.

Net cash stood at €0.1m at 30 June (€32.2m cash, €31.1m debt), down from €11.1m at year end. Cash outflows from acquisitions were €10.6m, while net cash inflow from operations was €4.0m (H117: £2.3m). The interim period is typically the trough for cash, with cash generation improving markedly in H2. This year we understand that a number of outstanding receivables came in shortly after period end, while Keywords should also benefit from the collection of accrued multimedia tax credits from previous years relating to the VMC acquisition (€14.7m on the balance sheet). With a revolving credit facility of €105 (at 1.5% above Euribor), Keywords retains plenty of firepower for future acquisitions.

We implement a precautionary £3.2m nudge down to our FY18 revenues, reflecting the muted revenue growth in H1 and recent closures. This is offset slightly by the small Trailer Farm acquisition with trailing revenues of £1.0m (€0.9m) and adjusted EBITDA of £165k (€150k). Our underlying earnings estimates are not significantly changed, offset by higher H2 margins. (VMC rationalisation and Gobo).

Looking longer term, if the games industry continues growing at a 10%+ rate, as forecast, we see no reason why Keywords should not be able to sustain a low to mid-teens organic growth rate, boosted by the trend towards outsourcing and market share gains/cross-selling.

The figures above clearly only incorporate acquisitions made so far. While it is impossible to forecast future acquisitions with any accuracy, the earnings accretion driven by future acquisitions is clearly core to Keywords’ investment case.

In Exhibit 10 we examine the potential impact that further acquisition activity could make to EPS over the course of the next 12 months. We assume that the company deploys €95m of cash in acquisitions between now and the end of FY19 and that these acquisitions are two-thirds funded by cash and one-third by equity at 1,800p.

We point out that this analysis is for illustrative purposes and not a forecast. However, it does suggest that if Keywords can maintain a low double-digit organic revenue growth rate and continue making acquisitions at a similar scale to FY16/17 at a 7–10x PBT level, the group’s EPS exiting FY19 could reasonably reach 85c+, 45% above our current FY19 EPS estimate. With additional capital from equity and in line with the company’s acquisitive strategy, the cycle could then repeat into FY20 and beyond.

The key attraction of Keywords’ business model and investment case is the fact that the company can continue generating robust, double-digit earnings growth without deviating from its current strategy or expanding beyond its core games developer customer base.

The company’s rating of 46x FY18e earnings, dropping to 37x in FY19e, is a substantial premium to peers (average c 23.4x for FY19e). We believe that a substantial premium is justified – Keywords has established a strong leadership position in an-end market with very attractive structural growth characteristics. Acquisitions should bring these multiples down substantially and there remains scope for organic upside to our estimates.

If we consider the scenarios portrayed in Exhibits 10 and 12, using in our opinion reasonable assumptions (similar organic growth trajectory and acquisition multiples), the company could expend its EPS to the 85c level exiting FY19, in which case the shares would be rated at a mid-20s multiple, in line with peers. With plenty of financial headroom to continue executing its current strategy, Keywords’ earnings growth potential should look equally strong into 2020 and beyond. Consequently, we would expect the company to continue to trade at a very healthy growth multiple. We believe that sustained execution should continue to drive robust returns for shareholders.