Keywords Studios — A diversified, resilient business in troubled times

In its COVID-19 update on 25 March 2020 (see our flash note), Keywords’ management stated that the business impact had been minimal in the first two months of the year, with some short-term disruption in China affecting the company’s five studios there. These have now returned to near full production. Since then, Keywords has seen disruption across all service lines and locations, mitigated by actions from its early experience applied across the group.

Functional Testing (21% of FY19 revenue), Localisation Testing (7%) and Audio Services (12%) (together representing c 40% of FY19 revenues and 38% of staff) have been most disrupted as these businesses have been harder to transition to remote-working – the testing businesses because of client concerns over the security of pre-release games and audio services as the high quality of sound studios is hard to replicate remotely. However, with revenues likely deferred rather than lost, some of the staffing costs have been offset through furloughing and the flexible cost base of freelance staff. Across the firm, 5,500 staff have now been moved to remote working, c 75% of total staffing.

Management also stated that it does not believe that COVID-19 will affect the business materially in the medium term, and indeed, it has already seen an increase in demand for services as existing and new clients re-appraise production arrangements and make contingency plans. Management hopes that Keywords will be able to benefit from this pent-up demand once the operating environment normalises, underpinning stronger expectations for FY21e.

The group has adequate liquidity, but nevertheless management has prudently sought to preserve cash, including cancellation of the FY19 final dividend payment. It is cash-generative, with FY19 cash conversion of c 79%, and has a strong balance sheet with net debt of €17.9m at 31 December 2019 (0.4x net debt/adjusted EBITDA). Keywords has total cash and undrawn facilities of €112m at 31 December 2019, including €30m of the RCF accordion facility currently being executed.

Please see our sector report, European video games: A safe haven in troubled times, published on 8 April for more information on the impact of COVID-19 on the gaming sector.

Certain sectors provide some respite for those in lockdown. The games sector is one, and as such is a beneficiary of the global lockdown. The transition from office work to remote working has caused significant business disruption, but for most games companies the disruption has been effectively managed, with business continuity plans now largely implemented. Its youthful workforce and agile development allow it to adjust to staff working from home, as well as to capitalise on back catalogues of existing games and mature digital delivery channels. Looking ahead, we see a period of three to six months with consumers isolated from normal activities and other forms of entertainment; while it lasts, this period will provide a substantial benefit for games companies. This is an acceleration of the digitalisation of the games industry. Thereafter, we expect the industry to return to its long-term growth trends (Newzoo: 8.4% CAGR 2019–22e).

We have revised down our estimates for FY20 to reflect the near-term challenges that we anticipate, particularly in H120, before Keywords can hopefully start to get back on track in H220. We have also introduced estimates for FY21 (Exhibit 1).

Trading in FY20 started in line with market expectations in the first two months of the year, with COVID-19’s impact limited to Keywords’ business in China. However, with the spread of COVID-19, we anticipate an impact on Keywords’ business in Q2 (particularly in Audio, Localisation Testing and Functional Testing), reducing in Q3 and thereafter. Although there is a significant chance of a global recession, we believe the games industry will prove relatively resilient, continuing to benefit from strong consumer demand. As such, we very much expect Keywords to get back on track quickly in H220, seeing a degree of catch-up from pent-up demand in FY21.

With current headwinds, we have pulled back our FY20 forecasts and assumed nominal revenue growth of 1% on the FY19 year-end revenue run rate. With the group’s investment in remote working (c 5,500 staff transitioned to date), furloughing of staff, lower productivity and investment in hardware and systems, we expect H120 margins to have been adversely affected and assume a 3% reduction in FY20 adjusted operating margins (14% to 11%), with PBT margins compressed to 10.5% from 12.5% in FY19.

As stated above, we expect Keywords to bounce back relatively quickly once global lockdowns ease (as has already been seen in its Chinese studios), supported by pent-up demand from its core client base wishing to keep major projects on track (particularly ahead of Thanksgiving and the Q4 console launches) and underpinned by strong consumer demand for games across all platforms and geographies.

Revenues: we have assumed 15% revenue growth with FY21 revenue of €390.4m, at the top end of management’s 10–15% guidance. This assumes a contained impact from COVID-19, with the company benefiting from a degree of catch-up from FY20, supported by the return of underlying growth in the games sector.

Margins: our 13.4% operating margin forecast builds on the 11.2% we now forecast for FY20. We believe the company could achieve a higher margin, but at this stage we would prefer to be conservative. We assume gross margins remain at c 37% for both FY20 and FY21.

Tax rate: through effective planning, Keywords’ tax rate has reduced steadily from 22% in FY16 to 18.2% in FY19. We expect this level is sustainable and forecast a tax rate of 18.2% in both FY20 and FY21.

Capex: as COVID-19 has bitten, management has put a temporary hold on discretionary capex spend. We expect capital spend to resume later in the year, with an element of catch-up in FY21. On this basis, we have assumed a c 25% fall in capex to €10.3m in FY20 (FY19: €13.1m), rising to €15.7m in FY21.

Deferred consideration: after a relatively quiet year for M&A in FY19 (eight acquisitions), the contingent consideration on the balance sheet fell from €19.3m at year-end 2018 to €6.0m at year-end 2019. We forecast that up to €5m will be payable in FY20 if performance conditions are met.

We have also assumed that tax credits – the Multimedia Tax Credit (MMTC – Canada) and the Video Games Tax Relief (VGTR – UK) – grow at 10% in FY21.

The final dividend for FY19 has been cancelled, meaning the total dividend payable for FY19 was 0.58p. We expect a resumption of dividend payments with the FY20 interim dividend, assuming 10% growth for the FY20 dividend over FY18. This implies a total FY20 dividend of 1.77p per share (FY18: 1.61p, FY19: 0.58p). We assume continuing 10% y-o-y dividend growth for FY21.

Keywords’ strategy of using earnings-enhancing acquisitions whilst consolidating a fragmented games outsourcing market is intrinsic to the investment case. Given the current environment and the steps management has taken to preserve cash, we do not anticipate M&A in H120. However, we may well see deals resume in H220 with distressed/ready sellers looking to exit towards the end of what will have been a difficult year for many.

The group retains good firepower for M&A with net debt of €17.9m, gearing of 0.4x net debt/adjusted EBITDA and total cash and undrawn facilities of €112m as at 31 December 2019. Although acquisitions are necessarily opportunistic, management’s focus is likely to be around building the group’s higher-margin marketing and development capacity.