Confidence in its sustainable model

Management offered a comprehensive review of the business and its drivers, sharing the stage with members of the Montreal and North American leadership team. The tone was open and reassuring, with ample time for Q&A.

This was the first event with Jon Hauck formally in place as CFO, who should bring useful experience to Keywords from his background at Rentokil Initial. We took reassurance that Keywords will continue to perform, balancing strong growth with a recovery of margins back to more normalised levels (c 15%) with M&A, particularly in games development and marketing, very much front of mind. Games remains the core focus, but opportunistic expansion into adjacent sectors (entertainment) should not be ruled out in due course.

Keywords remains the only games service provider with global scale, offering a suite of services across a range of geographies and of a quality and standard of professionalism that is catching the attention of the largest games studios (see Cross-selling and cross-delivery to become the ‘go to’ provider). Keywords continues to believe there may soon be a tipping point where a large games company (or a number of companies) hands over the responsibility for outsourcing to KWS to focus on its core creative game development.

Keywords remains a complex seat utilisation business. The logistics of putting teams together and scaling up and down with project demands is hugely complex and an area of real competitive advantage and differentiation. Keywords has proven ability to work in a distributed fashion, coordinating delivery from teams in different studios and locations although clients usually prefer the lead team to be local and based in the same time zone.

Historically, staff numbers have varied significantly through the year, with a peak between June and October. This cyclicality has moderated substantially in recent years, varying by less than 10% in FY19 because Keywords is now broader based and less dependent on consoles, and it reflects the increase in GaaS (Games as a Service) and DLC (downloadable content). Keywords also has an increasing range of evergreen project work, with teams providing multi-year post-launch support (as long as eight years in some cases).

The business has always valued flexibility, but with greater stability and predictability there is a strong argument to increase the ratio of permanent staff. Keywords recognises an increasing industry shift towards outsourcing non-core development, as publishers switch from having dedicated internal teams to leveraging Keywords’ services.

Since IPO, Keywords has completed 43 acquisitions across 18 geographies. Historically, most acquisitions have been priced between €3–30m, with an average historic sales multiple of 1.1x. Looking ahead, acquisitions of engineering and development studios were mentioned as the likely future focus and with only a few weeks to go until year end, Keywords did not rule out further acquisitions in FY19.

For M&A, Keywords does not use external advisers or participate in sale processes, with due diligence and integration led by Keywords staff and management. All companies are integrated with a structured transition plan and acquisitions tend to use a similar structure, pricing and methodology.

Keywords does not often 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 acquisition. In future, as well as looking for engineering and development studios, management indicated it would also consider opportunities to expand in adjacent sectors outside the games industry, although gave no defined timeline.

A number of studio heads presented to the audience, with case studies including Volta, Fire Without Smoke, Sunny Side Up, VMC and Snowed In Studios. The presenters delivered a consistent message, where each was acquired at a point where the business required increasing investment in admin and support functions, with the founding team being drawn away from its focus on the day-to-day business. Keywords was a welcome solution, taking away central functions, freeing up the management team to get back into the business and re-enabling growth.

Studios remain independent brands run semi autonomously with a high degree of independent decision making, but central functions are removed to become part of the Keywords family.

Keywords’ expansion strategy has been to establish a beachhead in a new territory through a single service line then expand the capabilities of that hub by building the suite of services. This strategy applies equally to clients, whereby a new client is won or acquired then cross-sold additional services to enable the relationship to be built and deepened. The breadth of Keywords’ acquisition strategy since IPO (43 deals across 18 geographies) highlights the effectiveness of this approach.

Keywords made the point that price is not normally the chief concern for most clients. Generally, trust, quality, flexibility, scalability and Keywords’ ability to offer a local point of contact are more important considerations than rock-bottom pricing. If pricing is critical, then Keywords can offer services from some of its lower cost locations.

Publishers and developers are beginning to realise that Keywords is better at managing outsourcing than they are. Keywords has more experience, better systems and more effective management processes than developers and publishers, so rather than getting a poorer solution through outsourcing (which may be their expectation), clients often get a better product than they would from managing the outsourcing process themselves. Keywords’ teams are involved in many more projects than in-house teams. As an indication, the Montreal studio has worked on >100 projects so far in 2019, whereas a larger publisher may only be working on c 10 projects.

Keywords avoids fixed price contracts – the risk is too high – it would prefer to walk away from a client than take on an unquantifiable level of risk. Keywords always prices based on time and materials, with clearly defined KPIs, milestones and break clauses. This approach, together with open and early communication with the client, is the only basis to build a long-term multi-project client relationship.

Keywords may look to increase its pricing, but the group will look to apply pricing more intelligently for projects that restrict Keywords’ flexibility through special conditions, such as high confidentiality, short notice projects, dedicated teams etc.

Management noted that most of its large contract wins over the last 18 months have come as a result of the VMC acquisition – the explanation is that large clients need a counterpart at scale and, following the acquisition of VMC, Keywords is increasingly being recognised by a number of major US clients as having the necessary scale and professionalism they are looking for. Although there are no immediate plans, the acquisition of VMC may allow Keywords the option to increase pricing in the future.

It is hard to document Keywords’ success at cross-selling, however, each of the studios presenting (Volta, Fire Without Smoke, Sunny Side Up, Babel and Snowed In Studios) talked about and could demonstrate both incoming and outgoing referrals within the group. This was reinforced by the finance function, with the number of inter-company transactions recorded by the finance team highlighting the success of Keywords’ cross-selling policy.

Organic revenues have grown at a 15% CAGR from €16m in 2013 to an expected (based on market consensus) €110m in 2019. Keywords has acquired revenue of €207m across 43 acquisitions at an average multiple of c 1.1x historic revenues. Consensus FY19e revenues are now forecast to be c €317m (vs our revenue forecast of €320m).

As reported in H119, the company saw exceptional organic growth that, together with advance investment in the Montreal facilities to support continuing growth, affected H1 margins. Keywords expects operating margins to recover steadily to c 15% over FY20 (vs 12.6% in H119). However, if there is an opportunity to benefit from continuing high revenue growth, management will look to capitalise on this, trading off additional growth for a slower normalisation of profit margins. Nevertheless, management expects margins to have normalised by the end of FY20 (vs our forecasts of 13.2% for FY19 and 14.9% for FY20).

To explain background growth, management broke down its organic growth expectations, showing why it envisaged 10% sustainable revenue growth in the medium to long term:

The last console transition (2013) was unexpectedly bumpy for Keywords in the run up to its IPO (over-exposure to a single key client). Keywords’ exposure to key console players is much lower than it was in 2013 and the business is more broadly based (the top five clients represent c 25% of revenues). In addition, the number of new distribution models such as mobile, VR, Stadia and Apple Arcade diversifies revenue sources. Clients tend to share their release roster with Keywords 12 months ahead for planning purposes. On this basis, although Q419 was relatively quiet in the run-up to Thanksgiving, the launch schedule for FY20 looks much busier.

Looking ahead to the forthcoming 2020 console transition, there are a number of factors that suggest the transition this time will be different: 1) consoles are a far less important part of the games mix than in 2013 (the number of new distribution models, eg Stadia, Apple Arcade, further diversifies revenue sources); 2) both major consoles are backwards compatible, so developers are likely to continue to focus on the current generation of consoles as the installed base of next-gen consoles builds; and 3) the increasing prevalence of the GaaS business model indicates a commercial rationale for a high level of ongoing support for ongoing titles on existing platforms.

We have taken advantage of the CMD to slightly update our forecasts, in particular taking account of the TV+ Synchron deal that completed shortly after the interim results.

In terms of valuation, Exhibits 9 and 10 below show Keywords’ comparator groups, both outsourcing and games companies. In terms of P/E multiples, Keywords continues to trade at a premium to its peer groups in the current year (FY19: 36.6x vs 25-30x), although with the strong EPS growth forecast, FY20 PE falls to 25.7x, in line with its peer group trading range (22-26x). Adjusted for blended average growth in FY19 and FY20, we derive a PEG ratio of 1.0x, materially below the majority of its peers (1.3-1.7x).

There is now limited scope for M&A in FY19, however accretive acquisition activity in FY20 (at multiples in line with historic levels) could bring the 2020e P/E down further. With strong underlying growth (10%+), we continue to believe sustained execution should drive robust returns for shareholders.

The CMD presentation is available on the Keywords website.

The full CMD video can be found at: https://www.youtube.com/watch?v=SUy8j73oNpc