Keywords Studios — M&A engine revving up again

Keywords Studios (LN: KWS)

Last close As at 28/03/2024

2,920.00

50.00 (1.74%)

Market capitalisation

2,207m

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Research: TMT

Keywords Studios — M&A engine revving up again

Keywords Studios has again showed the resilience of its model in H120, delivering 8% l-f-l revenue growth, 19% adjusted EBITDA growth and 17% adjusted EPS growth despite the impact of COVID-19. Adjusted EBITDA margins of 17.8% have held up better than we expected. Looking ahead, we see sustained industry growth, led by the console transition in Q420, with publishers increasingly recognising the resilience Keywords adds to their development processes. Following its third acquisition of the year, we see management once more focusing on M&A with net cash of €101m. Keywords’ strategy, which has delivered a five-year EPS CAGR of 42%, appears sustainable, with dividend payments to be resumed in FY21. As such, we believe that the shares remain set for continued appreciation.

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TMT

Keywords Studios

M&A engine revving up again

H120 results

Software & comp services

21 September 2020

Price

2,184p

Market cap

£1.61bn

€1.09/£

Net cash (€m) at 30 June 2020 excluding lease liabilities

101.0

Shares in issue

73.9m

Free float

90%

Code

KWS

Primary exchange

AIM

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(1.4)

21.1

80.1

Rel (local)

(0.4)

24.5

115.9

52-week high/low

2,274p

1,073p

Business description

Keywords Studios is the largest and most diverse supplier of outsourced technical and creative services to the games industry. Through regular acquisitions, the company is building its scale, geographic footprint and delivery capability to become the ‘go-to’ supplier across the industry.

Next events

Trading statement

January 2021

Final results

April 2021

Analysts

Richard Williamson

+44 (0)20 3077 5700

Dan Ridsdale

+44 (0)20 3077 5729

Keywords Studios has again showed the resilience of its model in H120, delivering 8% l-f-l revenue growth, 19% adjusted EBITDA growth and 17% adjusted EPS growth despite the impact of COVID-19. Adjusted EBITDA margins of 17.8% have held up better than we expected. Looking ahead, we see sustained industry growth, led by the console transition in Q420, with publishers increasingly recognising the resilience Keywords adds to their development processes. Following its third acquisition of the year, we see management once more focusing on M&A with net cash of €101m. Keywords’ strategy, which has delivered a five-year EPS CAGR of 42%, appears sustainable, with dividend payments to be resumed in FY21. As such, we believe that the shares remain set for continued appreciation.

Year end

Revenue (€m)

PBT*
(€m)

EPS*
(c)

DPS
(p)

P/E
(x)

Yield
(%)

12/18

250.8

37.9

45.5

1.61

52.3

0.07

12/19

326.5

40.9

48.8

0.58

48.8

0.03

12/20e

365.1

46.2

51.5

0.00

46.2

0.00

12/21e

412.5

53.4

56.4

1.95

42.2

0.09

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

H120: Resilient performance

Keywords has demonstrated its resilience in the face of COVID-19. Having downgraded our estimates at the start of the pandemic, this is our second upgrade for the year, with H120 revenues of €173.5m up 13% y-o-y, and up 8% on a like-for-like basis, with adjusted PBT increasing by 18% to €21.7m. Profit was boosted by a strong performance across its service lines, particularly Game Development, with Localisation and Audio showing weakest growth. At 30 June 2020, after the €110m share placing in May, net cash stood at €101m (H119: €9m net debt) with a further €100m of undrawn committed facilities.

Revised estimates for FY20 and FY21

Management has commented that H220 has started positively, with growth drivers for the medium term looking positive. As such, we have assumed continued 8% l-f-l growth in H220 (a conservative estimate), while also normalising PBT margins towards 13% in FY21. With three deals already announced this year, despite COVID-19, management reports a healthy M&A pipeline, with large as well as smaller deals, which should further support growth and earnings accretion.

Valuation: Continued execution to deliver upside

Sentiment towards the games industry is extremely positive, given the sector’s performance this year and its outlook. As such, Keywords’ shares trade on an FY20e P/E of 46.2x, falling to 42.2x in FY21e. We see scope for organic upside as well as the potential for material accretive acquisition activity with €100m+ for M&A (see sensitivity analysis, Exhibits 2 and 3). Keywords’ strategy, which has delivered a five-year EPS CAGR of 42%, appears sustainable. In this context, we believe that the shares remain set for continued appreciation.

Keywords Studios is a research client of Edison Investment Research Limited

FY20 and FY21 estimate revisions

Based on the H120 results, we have updated both our FY20 and FY21 estimates. Our latest estimates are shown in Exhibit 1.

Revenues: As the business has proven that it can work flexibly (although Audio and Localisation would be challenged if there were further lockdowns), we have raised our growth forecasts for FY20 to 8% to reflect the 8% l-f-l revenue growth seen in H120. For FY21, we had previously assumed a bounce back in demand. Given the fall in FY20 has not been as severe as first anticipated, we have also pared back the growth recovery in FY21, forecasting l-f-l organic growth of 12% from 15% previously. We then forecast conservative ongoing growth of 10%, in line with management guidance.

Margins: Management have been confident that margins are building towards historical norms. They had expected this to occur in FY20, but have commented that COVID-19 has delayed the normalisation process by c 12 months. As such, we assume a 13.6% operating margin for FY20e, a slight increase on 13.2% in H120. For FY21, we continue the upward trend, with the operating margin rising to 13.8%. We believe this level leaves headroom for reinvestment in growth. Otherwise, we have assumed gross margins remain c 37% for both FY20 and FY21.

We have also updated the model for the three acquisitions completed in FY20.

Exhibit 1: Revised estimates

€'000s

2019

2020e

2020e

Estimate

2021e

2021e

Estimate

Y-o-y

Year end 31 December

Actual

Old

New

Change

Old

New

Change

Change

Revenue

 

 

326,463

352,895

365,056

3.4%

405,829

412,461

1.6%

13%

Gross Profit (inc multimedia tax credits)

120,229

131,636

138,021

4.9%

151,593

153,868

1.5%

11%

Gross Margin (%)

36.8%

37.3%

37.8%

37.4%

37.3%

EBITDA (Adjusted)

 

 

57,611

55,037

64,066

16.4%

70,531

77,560

10.0%

21%

Operating Profit (before amort. and except.) 

42,983

39,883

49,677

24.6%

54,194

56,939

5.1%

15%

Operating Margin

13.2%

11.3%

13.6%

13.4%

13.8%

Profit Before Tax (norm)

 

 

40,913

37,283

46,177

23.9%

51,594

53,439

3.6%

16%

Profit After Tax (norm)

33,451

30,483

37,755

23.9%

42,184

43,693

3.6%

16%

EPS - normalised (c)

 

 

48.8

41.9

51.5

23.0%

55.0

56.4

2.5%

9%

Dividend per share (p)

0.58

1.77

0.00

1.95

1.95

Source: Company accounts, Edison Investment Research

Management has stated an intention to continue with its progressive dividend policy from FY21.

Acquisitions

To date, management has announced three acquisitions in FY20, one in H120 and two after the period end in H220 – all three have been in Game Development or Marketing Services. After an understandable hiatus in H120 as the business adjusted to the challenges of COVID-19, Keywords completed its placing, raising €110m to strengthen the balance sheet as well as to provide additional capacity for M&A. All three transactions followed the placing:

Up to £2m – Coconut Lizard, Game Development (June 2020) – a Gateshead-based provider of game development engineering services (game optimisation, game hardening, porting and middleware integration) acquired for up to £2m (1.3x historical revenues, 5.7x adjusted EBITDA), two-thirds upfront, one-third deferred. With c 30 staff, Coconut Lizard specialises in the Unity game engine and has a strong relationship with Microsoft’s Rare studio.

Up to £3.6m – Maverick Media, Marketing Services (August 2020) – a London-based video game creative agency with a track record in TV commercial and live action projects in addition to video game trailers, key art and social media. Keywords paid up to £3.6m (1.04x historical revenues, 3.6x adjusted EBITDA), £2.7m of non-contingent consideration (£2.4m in cash, with £0.3m in equity to be issued after 12 months) with an additional amount of up to £0.9m payable in a mixture of cash and equity dependent on business performance in the six6 months following completion.

Up to US$13.3m – Heavy Iron, Game Development (September 2020) – a Los Angeles-based games developer, with a 43 strong team that provides game development, co-development, live operations and porting services. Heavy Iron has multiple proprietary engine technologies and development experience across all major platforms, particularly PC and console, with recent projects for Crystal Dynamics, Disney and Activision. Keywords paid up to US$13.3m (2.5x historical revenues, 13.3x adjusted EBITDA), with US$4.5m payable upfront and a performance-related payment of US$8.8m in a mixture of cash and shares, one and two years from completion. The acquisition also delivers Keywords a foothold on the US West Coast, close to the head offices of many of the major games publishers.

Strong acquisition pipeline to support growth

Keyword’s strategy of making earning enhancing acquisitions while consolidating a fragmented market is intrinsic to the investment case. Management has stated the acquisition pipeline remains strong and that it continues to receive healthy inbound interest from around the world. The pipeline contains both large, transformational acquisitions as well as small and mid-sized deals. With net cash of €101m and an undrawn committed revolving credit facility of up to €100m, the company retains good firepower for M&A activity, with the company guiding towards €100m of acquisitions over the next 18 months.

By its nature, the acquisition process is opportunistic, but management has highlighted Game Development and Marketing Services (where all three deals completed so far in FY20 have been) as the two most likely areas for future acquisitions.

While our base case estimates do not reflect any contribution from M&A, our sensitivity analysis in Exhibits 2 and 3 suggests that if management retains historical price discipline (ie paying 7–11x EV/PBT for acquisitions) and deploys €100m in cash (plus equity, assuming a 70/30 cash/equity split) on acquisitions, then, based on a notional 18% tax rate, it is reasonable to expect at least 50% accretion to our FY21 normalised EPS estimate.

Exhibit 2: Sensitivity analysis – FY21 EPS (c) adjusted for €100m in cash (plus equity) to be spent on acquisitions

Average EV/PBT paid for acquisitions (x)

7.0

8.0

9.0

10.0

11.0

Organic revenue growth

10.0%

104.5

96.9

91.2

86.8

83.2

12.5%

106.2

98.5

92.8

88.3

84.7

15.0%

107.8

100.1

94.3

89.8

86.3

Source: Edison Investment Research

Exhibit 3: Sensitivity analysis – Acquisition adjusted FY21 EPS (c) accretion

Average EV/PBT paid for acquisitions (x)

7.0

8.0

9.0

10.0

11.0

Organic revenue growth

10.0%

92%

78%

67%

59%

53%

12.5%

95%

81%

70%

62%

55%

15.0%

98%

84%

73%

65%

58%

Source: Edison Investment Research

Exhibit 4: Sensitivity analysis – Acquisition adjusted FY21 P/E (x) (assuming a share price of 2,184p)

Average EV/PBT paid for acquisitions (x)

7.0

8.0

9.0

10.0

11.0

Organic revenue growth

10.0%

24.7

26.4

27.9

29.2

30.4

12.5%

24.3

26.0

27.4

28.7

29.8

15.0%

23.9

25.5

27.0

28.2

29.2

Source: Edison Investment Research

Exhibit 5: Financial summary

€'000s

2017

2018

2019

2020e

2021e

Year end 31 December

IFRS

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

 

151,430

250,805

326,463

365,056

412,461

Cost of Sales

(96,345)

(154,997)

(206,234)

(227,035)

(258,594)

Gross Profit (inc multimedia tax credits)

55,085

95,808

120,229

138,021

153,868

EBITDA (adjusted)

 

 

26,645

43,729

57,611

64,066

77,560

EBITDA (reported)

 

 

22,203

34,304

43,375

54,355

65,732

Operating Profit (before amort. and except.)

 

 

23,915

38,916

42,983

49,677

56,939

Amortisation of acquired intangibles

(3,038)

(6,872)

(7,318)

(11,324)

(12,868)

Exceptionals

(3,016)

(5,296)

(4,348)

(2,370)

0

Other (incl share based payments)

(1,426)

(4,129)

(9,775)

(10,753)

(11,828)

Operating Profit

16,435

22,619

21,542

25,231

32,244

Net Interest

(818)

(1,316)

(2,513)

(3,500)

(3,500)

FOREX

(3,623)

791

(1,658)

0

0

Profit Before Tax (norm)

 

 

23,097

37,911

40,913

46,177

53,439

Profit Before Tax (FRS 3)

 

 

11,994

22,094

17,371

21,731

28,744

Tax

(4,731)

(7,191)

(7,462)

(8,422)

(9,747)

Profit After Tax (norm)

18,366

30,720

33,451

37,755

43,693

Profit After Tax (FRS 3)

7,263

14,903

9,909

13,309

18,997

Average Number of Shares Outstanding (m)

58.7

64.3

65.1

69.5

74.0

EPS - normalised (c)

 

 

31.3

45.5

48.8

51.5

56.4

EPS - normalised fully diluted (c)

 

 

30.0

43.7

47.2

49.6

54.5

EPS - (IFRS) (c)

 

 

12.4

23.2

15.2

19.1

25.7

Dividend per share (p)

1.46

1.61

0.58

0.00

1.95

Gross Margin (%)

36.4%

38.2%

36.8%

37.8%

37.3%

EBITDA Margin (%)

14.7%

13.7%

13.3%

14.9%

15.9%

Operating Margin (before GW and except.) (%)

15.8%

15.5%

13.2%

13.6%

13.8%

PBT Margin (%)

15.3%

15.1%

12.5%

12.6%

13.0%

BALANCE SHEET

Fixed Assets

 

 

142,927

198,215

223,992

220,723

216,965

Intangible Assets

131,610

180,086

196,769

192,087

182,342

Tangible Assets

10,111

15,002

22,163

23,577

29,564

Investments

1,206

3,127

5,060

5,060

5,060

Current Assets

 

 

80,182

100,348

120,483

251,172

294,423

Stocks

0

0

0

0

0

Debtors

27,473

37,019

43,243

46,702

52,307

Cash

30,374

39,870

41,827

166,224

199,280

Other

22,335

23,459

35,413

38,246

42,836

Current Liabilities

 

 

(51,677)

(95,031)

(49,551)

(49,948)

(47,478)

Creditors

(32,734)

(54,960)

(49,471)

(49,868)

(47,398)

Short term borrowings

(18,943)

(40,071)

(80)

(80)

(80)

Long Term Liabilities

 

 

(10,420)

(11,158)

(71,528)

(71,194)

(73,194)

Long term borrowings

(337)

(230)

(59,671)

(59,671)

(59,671)

Other long term liabilities

(10,083)

(10,928)

(11,857)

(11,523)

(13,523)

Net Assets

 

 

161,012

192,374

223,396

350,754

390,716

CASH FLOW

Operating Cash Flow

 

 

21,389

33,954

46,069

60,487

67,750

Net Interest

(253)

(502)

(9,411)

(6,263)

(3,425)

Tax

(4,731)

(6,304)

(13,288)

(8,422)

(9,747)

Capex

(3,803)

(9,440)

(13,145)

(11,024)

(16,608)

Acquisitions/disposals

(90,090)

(25,766)

(27,762)

(7,380)

(3,470)

Financing

82,936

0

0

97,000

0

Dividends

(867)

(1,080)

(1,197)

0

(1,444)

Net Cash Flow

4,581

(10,090)

(18,734)

124,398

33,056

Opening net debt/(cash)

 

 

(8,650)

(11,094)

431

17,924

(106,474)

Forex gain on cash

(891)

(3)

1,293

0

0

Other

(1,246)

(1,432)

(52)

0

0

Closing net debt/(cash)

 

 

(11,094)

431

17,924

(106,474)

(139,530)

Source: Keywords Studios accounts, Edison Investment Research


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