Keywords Studios — Deeper, wider, higher

Through a combination of robust organic growth and acquisitions, Keywords has transformed itself from a small specialist supplier of localisation services to the largest and most diverse supplier of services to the global games development industry.

FY17 was the company’s most transformational yet, with 11 acquisitions completed for a total €99m consideration (of which €87m was cash), including two of the company’s largest to date – VMC for $66.4m and Sperasoft for $27m.

Through its seven service lines, the company now provides service spanning most of the games development cycle – from original concept to going live. The company has a presence in most of the major games development hubs and services 23 of the top 25 games companies globally with no customer accounting for more than 10% of revenues. At the same time, the number of clients using three or more of the Keyword’s services rose to 93 from 64 last year, boosted by acquisitions and the improved opportunity for cross selling as the portfolio is expanded.

A key feature of recent M&A has also been the company’s move into domains that are closer to the core games creation operations. This process started with the company’s move into art (six acquisitions over the last 24 months) while 2017 saw the company take its first steps into engineering (with the acquisitions of GameSim, d3t and Sperasoft). The acquisition of VMC established the group as the leading global provider of functional testing services, expanding the company’s capability to include a global beta testing network and testing services embedded at the client’s site.

This evolution is key to enabling the group to establish deeper, multi-faceted strategic relationships with its client base and early signs are positive. The company has reported a number of early wins for co-development services, whereby clients essentially outsource significant parts of, or even full, games to Keywords. Examples cited by management include remastering an older game as part of a port to a new platform, being chosen as the only external studio (of a total of five or six) to develop a complete segment of a game or developing a complete game.

Keywords reported l-f-l growth of 15.1% in FY17, accelerating from 12% in FY16, although we believe that underlying performance was actually stronger than this, in the 18–20% range. This is because the company reports its like-for-like figures including the pro-forma contribution of acquisitions made during the period. Keywords has a demonstrable track record in accelerating the growth of the company’s it acquires, but major acquisition activity in FY17 was back-end weighted and therefore there was not much time for revenue synergies to come through.

We estimate that like-for-like growth excluding in-year acquisitions was c 18%. Stripping out just VMC (pro forma revenues of €50m), which is a turnaround and has not been growing, we estimate l-f-l growth was closer to 20%. Moreover, l-f-l growth in H1 (as reported at the interims), not including VMC, was 17%, implying that l-f-l growth (ex VMC) accelerated in H2.

The l-f-l growth rate is also well above that of the 10.3% for the global games industry estimated by Newzoo, we believe driven by a combination of growth in the outsourcing market overall and by market share gains.

We believe that the trend towards outsourcing in the games industry could accelerate, driven by consolidation in the games production industry, the increased complexity of games, the adoption of leaner operating structures and the industry’s shift to a much more recurring, franchise-based subscription model (demanding regular content updates). The extent to which outsourcing has been adopted varies by service line (Exhibit 2), but management believes c 50% of spend in the services it offers is currently outsourced and that this will move to 70–80% over the next five years. This would imply a low- to mid-teens CAGR for the outsourcing industry over this period.

We believe Keywords is well placed to continue gaining market share. The outsourcer supplier landscape remains over fragmented and we believe a greater proportion of business will gravitate to players with more scale, stronger processes and financial strength. As the company’s platform grows, so does its platform for cross-selling and developing deeper relationships with clients.

M&A activity resumed in April, following a brief pause for breath in Q1, with two smaller tuck-in acquisitions to enhance the audio service line announced with the results. The acquisition of Cord Worldwide and Laced Music, both acquired from Cutting Edge Group for £4.5m (€5.3m), add capabilities in music to complement the company’s voice audio capability for a modest 7x PBT multiple. Maximal adds voiceover recording capability in Brazil for an initial cash consideration of €0.3m, with a performance-related deferred consideration of up to €0.2m.

The company reports a healthy pipeline. As in other years, this is likely to include a number of smaller tuck-in acquisitions such as Cord, Laced and Maximal, together with one or two larger, more strategic ones. We expect further activity in engineering as the company builds out its co-development operations, while Game Trailers and Analytics have been flagged as potential new areas in which to expand.

The company’s headroom to pursue its strategy has been significantly expanded by agreeing terms for three year €75m bank facility, replacing the current €35m facility with the option to extend this to €105m. Factoring in the reinvestment of free cash flows, the €75m facility should give the company at least €90m firepower, which could be deployed before Y/E18. Even without factoring in the EBITDA or cash flows contributed by future acquisitions, this would still leave net debt/EBITDA below a comfortable 1.5x level.

The earnings accretion driven by future acquisitions is clearly core to Keywords’ investment case. While it is not possible to forecast future acquisitions, our scenario analysis in Exhibit 3 examines 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 FY18 and that these acquisitions are two-thirds funded by cash and one-third by equity at 1,750p.

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 FY18 could reasonably reach c 75c, more than double the FY17 figure and c 60% above our current FY18 EPS estimate. With additional capital from equity and following the company’s acquisitive strategy, the cycle could then repeat into FY19.

Acquisitions are funded two-thirds by cash, one-third by equity (similar to many historical deals), with the shares priced at 1,750p (current share price at the time of writing). As we have seen with VMC, strongly accretive acquisitions can also be funded by raising equity, but there are too many variables to build such deals into this analysis.

We upgrade our FY18 and FY19 EPS by 3% small organic upgrades and the acquisitions, but see plenty of scope for the organic and acquisition upgrade cycle to continue (see Exhibit 4 below).

Our FY18 revenue forecast of €249m assumes 7.8% like-for-like growth rate on FY17 pro-forma revenues of €224.4m, although on a constant currency basis, this is more like 13%, due to the c 8% ytd weakening of the US dollar vs the euro. In FY17, 46% of revenues were US$ denominated but this will grow with the VMC and Sperasoft acquisitions. Costs are typically well matched with revenues, so the impact is largely translational.

We also need to take into account that VMC is likely to be a continued drag on like-for-like growth given the restructuring being implemented.

Nevertheless, given the company’s recent accelerating growth profile and good progress in winning co-development services, we see good potential for our forecasts to move up again as the year progresses.

Operating margins were broadly flat year-on-year at 15.8% in FY17. Our forecast drop to 15.1% factors in the absorption of VMC (which contributed at 11% margin from acquisition to FY17), with expansion again in FY19 as VMC restructuring benefits are released.

We believe there is scope for margins to expand, driven by scale and operational efficiencies but whether this happens depends on how management chooses to balance margins versus growth. Recent performance clearly indicates that investing incremental margin back into growth generates a strong ROI.

Effective tax planning has enabled the group to reduce its tax rate from 22.9% in FY15 to 20.5% in FY17. We expect this trend to continue, with the group making good use of the low corporate tax rate in Ireland supported by the federal corporate tax rate reductions.

While operating cash flows dropped to €13.6m from €15m in FY16, this was depressed by significant acquisition related items, particularly relating to VMC and the underlying business continues to generate healthy cash flows. Adjusting out these items operating cash flows would have been €21.9m vs €23.9m adjusted operating profit.

The company’s rating of 43x FY18e earnings, dropping to 40x in FY19e, is a substantial premium to peers (average c 27x for FY19e). The company’s track record of generating earnings growth is exceptionally strong; over the past five years Keyword’s has generated a revenue and EPS CAGR of 77% and 53% respectively. The company’s price/earnings growth ratio (PEG) for FY16/18 is a modest 0.8x.

Moreover, this is a business with a leading market position within a structural growth market and a strategy for strengthening this further, while enhancing its earnings whilst it does so. As a result, we believe that the company has a platform to continue generating robust double-digit earnings growth without deviating from its current strategy or expanding beyond its core games developer customer base.

Moreover, acquisitions should bring these multiples down substantially. We believe that our like-for-like growth estimates are conservative and there is scope for margin expansion.

As highlighted in Exhibit 3, deployment of the company’s acquisition capital could bring the multiple down to c 30x by the end of FY18. With plenty of financial headroom to continue executing its current strategy, Keywords’ earnings growth potential should look equally strong looking into 2019 and beyond.

In summary, it is difficult to see a catalyst for a further upwards rating in the short term but if the company continues executing as it has done, it should also continue to deliver robust investor terms on a medium-term time horizon.