Keywords Studios — Compelling game plan, executed well

FY16 was a strong year for Keywords Studios, both operationally and financially. Like-for-like growth (calculated as if acquisitions had been included for equivalent prior year periods) was a very healthy 24%, with all service lines bar localisation testing (8%) growing like-for-like revenues at a strong double-digit rate. As previously flagged, performance across localisation and audio was boosted by a particularly strong performance from Synthesis, acquired in April, during the second and third quarters, which management estimates boosted revenues by c €4m above the usual run rate.

Growth is being supported by a generally buoyant environment in the global games development industry; market analyst Newzoo estimates the industry grew 8.5% in 2016 and will expand at an annual rate of 6.6% through to 2019. We believe that Keywords’ more rapid growth rate is being driven by a combination of factors:

Keywords Studios made eight acquisitions over the course of the year, paying a total of €20.1m cash, 585.6k shares with a total c €2.1m deferred or contingent consideration for the acquired companies. Whereas in FY15 the company established two new service lines through acquisition, in FY16 the focus was on strengthening its position in established service lines.

The largest acquisition, Synthesis (€10.2m plus 2.4m shares), boosted the company’s position across translation, audio and to a lesser extent localisation testing. It performed particularly well, with the business contributing €18m revenues and €3.5m PBT over the period, well above the €10m and €1m respective figures we forecast at the time of the acquisition.

The company extended its position in art, adding early stage concept art studio Volta. Since year-end, the acquisition of Spov for up to £1.2m adds cinematics, user interface, visual effects and motion graphics capability to the equation.

The acquisition of Enzyme boosted the company’s position in localisation and functional testing. The studio also provides focus group testing services for optimising game design and user experience. This is a new domain for Keywords, but should complement the activities of its Player Research operations, acquired in October, and support the company’s drive to build more comprehensive, retained, strategic relationships with clients.

We expect the pace of M&A to continue, and perhaps accelerate. The company has €17m of cash on the balance sheet with borrowings of €8.4m but has also announced that it has reached a heads of terms agreement with Barclays for a €35m revolving credit facility. Taking into account our forecast that the company will generate net cash flow of €10.9m of cash in FY17, the company has the firepower to spend circa €50m on acquisitions over the course of the year without requiring equity or stretching net/debt to EBITDA beyond a reasonable 2x threshold.

The key strategic priority, from an M&A standpoint, is likely to be the addition of capability in engineering (ie coding, for example to port games to different platforms, etc), which has the potential to grow into a major service line and which management believes is ripe for outsourcing with strong cross-sell potential. The company is also looking at opportunities in games analytics, an area that is seen as offering strong growth potential.

Following on from the acquisition of Spov, the company plans to extend its capabilities in areas such as visual special effects, user interface design, cinematics and motion graphics. The Spov acquisition also give Keywords a toe hold in the film/video production industry, where management also sees opportunities for localisation and audio as production cycles accelerate and the rise of global players such as Amazon and Netflix drive demand for localisation services.

Management is taking steps to ensure the model continues to scale, through investment in core platforms in some areas and increased decentralisation in others. These are summarised below:

Group level – The company is investing in a new accounting platform, which will be rolled out across the group over the next 12-18 months. Over the course of the year, the executive team was strengthened with the addition of David Broderick as CFO and Jaime Gine as chief commercial officer. A global director of IT has been appointed and the company is recruiting a group head of HR. A unified sales team also facilitates cross selling.

Service line – Each service line (which comprises a number of studios) is run on a global basis, led by a global service head, whose responsibilities include defining and executing the M&A strategy for the segment. All service lines other than Art now use a common operating platform across their studios for project management, workforce and operational reporting.

Regional – Service lines are supported by regional management teams. The company is generating cost synergies through consolidating studios into shared offices in Montreal and Madrid and with plans for London as well.

We have nudged up our FY17 estimates slightly (detailed in Exhibit 3), while our FY18 estimates are new. We believe that they remain conservative at all levels. Our FY17 revenue estimate implies a mere 3% like-for-like growth – although if we adjust for the circa €4m of above run rate revenues from Synthesis this increases to 7% – still significantly below the 20% (Synthesis adjusted) level from FY16. We assume 8% like-for-like growth in FY18.

Gross margins in FY16 were 35.6% (38% including games development tax credit), up from 35.4% last year, although the exceptional trading and utilisation at Synthesis did boost this figure. We are forecasting a return to previous levels in FY17 due to this not repeating, although there may be scope for some upside, as on a blended group basis, the company is not seeing any significant changes in either price or cost pressure.

We expect to see some benefits from operational gearing at the admin expenses level, which we forecast dropping to c 20% of revenues versus the 22% level in FY16.

We also forecast a progressive 1% pa reduction in tax rate over the period (21.7% in FY16) as the company leverages its diverse geographical footprint to improve tax efficiency.

The company generated free cash flow (including capex, tax, interest but not acquisitions) of €12.7m over the period although this figure was supported by a catch up in multimedia tax credits (€1.6m), Adjusting for this, free operating cash flow per share (19.2c) was within 6% of EPS adj (20.3c). Keywords’ business model requires only modest working capital and capex investment and hence we expect the company to continue generating healthy cash flows on an underlying basis.

At 34x FY17 earnings dropping to 32x in FY18, Keywords’ rating is a substantial premium to peers (average 18x for FY18).

However, the company has a compelling platform and strategy for growth within a games industry growing at a healthy 6.6% pa, with a strong track record of execution. Further accretive acquisition activity should be expected. Our organic estimates are conservative given historical and market growth rates, and the securing of a major strategic outsourcing deal could provide a further boost to forecasts. So while we believe that strong progress is now priced in for this year, if the company executes to plan it should grow into this valuation and continued execution should continue to deliver upside for shareholders.

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