Keywords Studios — Update 7 April 2016

Keywords Studios provides a range of technical outsourcing services exclusively to video games developers and publishers. It is game and platform agnostic and its services are spread across the video games development lifecycle covering six clearly distinct delivery offerings: art production, functional testing, localisation, audio production, localisation testing and community management. Of these, localisation and localisation testing represent the predominant proportion of revenues (30% and 26% respectively in FY15). Keywords employs more than 1,300 people at peak times working for clients in more than 50 languages, from 17 studios in more than 15 countries including locations in Ireland, the UK, US, Brazil, India and Japan.

Keywords trades on a P/E of 19.2x (FY16e), falling to 16.7x (FY17e) and an EV/EBITDA of 11.8x (FY16e), dropping to 10.3x (FY17e). These multiples are broadly in line with localisation peer SDL, but below the broader video game publishing peer group despite the fact that Keywords benefits from high levels of revenue and profit visibility. The biggest positive share driver is likely to come from further accretive M&A, which continues to expand its service offering, and evidence that the multi-service expansion is leading to increased penetration among its customers via the significant opportunity to cross-sell. This will require continued successful integration of the company’s recent acquisitions at the sales and marketing level.

FY15 y-o-y organic revenue growth was 20%, continuing the recent strong trend (FY14: 23%). While we expect this level of growth to moderate somewhat in 2016, we still expect it to remain solid in the medium term at around 12% in FY17. We forecast that this performance will again be further boosted by M&A in the coming year.

Given the fragmented nature of the video game outsourcing market, we believe there remains considerable scope for Keywords to continue its buy-and-build strategy. So far, acquisitions have been funded without the use of debt. The company has a sound balance sheet with €17.3m of net cash at end December 2015 following its successful November 2015 equity issue, which raised £10.5m (gross). This allows the flexibility for Keywords to pursue a number of further deals from its existing financial resources, although the company may seek further debt or equity funding should a larger deal become available.

M&A: acquisitions continue to form a large part of Keywords’ growth strategy; the ability to find and successfully integrate attractively valued targets is a key sensitivity for the company. As the company scales up, its intra-company relationships are likely to become more complex, requiring greater management attention. Competition: globally, there are a number of larger non-video gaming localisation companies (eg SDL, Lionbridge Technologies and RWS). They could potentially enter the video games localisation market and force Keywords to compete more on price, affecting margins in this segment of its business. Resourcing: as Keywords gets bigger, it faces a challenge to attract and retain high-quality staff, particularly in its localisation segment where it relies on native tongue talent. This is mitigated by the fact that much of its expansion is taking place via moves into new geographies, which mitigates any potential local market labour market saturation issues it might face.

Keywords Studios provides a range of technical outsourcing services exclusively to the video games industry. Having established itself in the areas of functional testing, localisation and localisation testing, Keywords has used a number of strategic acquisitions to meaningfully increase its product offering into complementary service verticals, such as art production and community management, where it has historically had little or no offering. This has increased the potential for significant cross-selling opportunities as developers are increasingly looking for ways to save costs and increase flexibility by outsourcing the less creative parts of the development cycle, but to a progressively smaller list of trusted partners.

Headquartered in Dublin, Ireland, Keywords began in 1998 as a localisation service provider. It largely consisted of translation services provided to the business software industry. Over time, it also began to service the video games industry. After successfully developing an efficient simultaneous localisation and functional testing approach, in 2005 the company made the strategic decision to focus on servicing the video games industry. The current CEO Andrew Day joined the company in 2009 with the remit of pursuing both strategic and geographic growth opportunities. International expansion came first in 2010 with the establishment of a Tokyo office. Over the last six years the company has significantly expanded its international presence and now has offices in Brazil, Canada, India, Ireland, Italy, Japan, the Philippines, Singapore, Spain, the UK and the US. Its most recent acquisition of art production company Mindwalk will take it into the highly attractive, generally locally serviced Chinese market. Its numerous acquisitions have also expanded its product offering to offer support across the production and post-production stages of the games development lifecycle. Keywords listed on AIM in July 2013 (when it raised £10.0m at 123p/share).

Organic and acquisitive growth has enabled Keywords to become the primary global provider of outsourced technical services to the strongly growing video games industry. While there is scope to increase the number of customers it serves, Keywords’ growth strategy largely consists of continuing to use its size and breadth of offering to successfully cross-sell to increase penetration in its already impressive customer base by offering its clients more services in more locations. The company’s recent acquisitions have significantly increased its potential share of customer spend.

Keywords is fundamentally a people business. As such, it is capital-light but labour-intensive and its staff utilisation rate directly affects its profitability. The careful management of its staff base is pivotal to ensuring that it has access to the required languages and skill sets to conduct the necessary service delivery in a timely manner. Its competitive advantage, which has increased as it has grown, is its ability to offer a broader range of services, while keeping its staff utilisation rate higher than a smaller-scale provider (or internal team) could, given the industry’s seasonality. This enables it to provide the same or better level of service at a competitive price.

Keywords keeps utilisation high by relying on a deep pool of contract labour and employing experienced and highly skilled workers as full-time equivalents (FTEs) to manage that pool of workers. This allows it to keep a tight control on its costs, while still offering the flexibility to vary its capacity from its FY15 average headcount of 1,273 (up from 978 in FY14), to a FY15 peak of 1,410 reached during the seasonally busy summer period.

Utilisation also benefits from good visibility from developers about which games Keywords will be instructed to work on. Management estimates that it has c 85% visibility on order flow for the year.

Along with efficiency, Keywords adds value via its reputation for quality, as evidenced by its tier one client base and high retention rate. It only uses native speakers to carry out its localisation services and its core staff incorporates a number of experienced project managers. Together, they ensure a consistency of quality that is essential for winning and retaining business.

Although revenue from customers is not typically contractually recurring, once Keywords establishes itself with a games developer, the developer tends to keep going back, particularly if the game is a new generation of the same title (eg Halo 1, 2, 3, 4, etc), or where Keywords is embedded in a continual localisation work stream. Keywords’ good reputation among its clients is demonstrated by the fact that it achieved a 70% increase in the number of clients that use it for three or more services since 2014 to 51 in 2015.

The release of the eighth-generation video games consoles (Xbox One and Playstation 4), together with the rise of online and smartphone/tablet gaming, has served to increase both the complexity of video games development and the amount of post-release support required. In response, video games developers are increasingly likely to outsource less proprietary elements of the games development lifecycle to companies such as Keywords Studios.

The move to digital distribution and the new monetisation models to which it has given birth over the last three years is fundamentally changing the video games industry in a number of ways. This has led to content growing faster than the overall market as the old perpetual licence, ‘big bang’ release cycle is increasingly replaced by a more iterative approach to game upgrades. In-game purchasing, ad-supported, free-play models and real-time updates that reflect up-to-date real world developments only serve to increase the weight of content that publishers need to produce to keep gamers adequately engaged, while also creating new service areas such as online community management.

The internet as a tool for digital distribution, exploding smartphone penetration and rising incomes in many developing countries, have significantly increased the market for video games. The highest rates of growth in the industry can now be found in markets like China (which is believed to have recently surpassed the US as the largest single market) and Latin America. A ‘one-size-fits-all’ approach is increasingly insufficient for games publishers that want to engage a truly global audience. As a result, developers are embracing higher levels of localisation to broaden the appeal of their games beyond the traditional markets.

Consistent with the growth in smartphone penetration, mobile gaming revenue growth is expected to continue to outstrip that found in the console segment (9.6% vs 4.9% expected CAGR to 2018, source: PwC). Total mobile revenues are thought to have surpassed those of traditional console gaming for the first time in 2015. Importantly, they estimate that this is additive revenue to the industry, rather than a cannibalisation of console revenues. Mobile games are becoming more sophisticated as they graduate into the ‘mid-core’ space. However, they continue to be generally less complex and are developed by smaller development teams that are less likely to have the ability and/or capacity to carry out localisation activities themselves. They are also usually translated into more languages due to the ease of distribution through app stores.

Exhibit 1 shows the breakdown of the key parts of the games development lifecycle. Services in green are provided by Keywords and components in grey are typically carried out by the games developer or publisher.

Keywords is the biggest provider of localisation services in the video games industry. This is illustrated by the fact that it has 20 of the top 25 games publishers among its client base, including Microsoft and Electronic Arts. Its strong position is replicated in the relatively immature mobile gaming space, where it counts seven of the top ten dedicated mobile developers among its clients.

There do not appear to be any other providers that offer either Keywords’ range of services or its geographical coverage. There are companies that offer similar services in other industries such as RWS and Lionbridge Technologies. These companies are well established and have much larger revenues than Keywords. Therefore, given the growth in the video games industry, the potential for these or other companies to attempt to enter the market should not be ruled out, although it should be noted that acquiring Keywords could be one such market entry strategy.

Competition from translation software providers should also be considered, although there are presently no software solutions capable of translating with the level of natural language and cultural relevance that is required by the video games industry.

We expect that the growth in demand for outsourced technical services will be driven by a number of factors in the short to medium term, summarised in Exhibit 2 below.

The recently announced acquisition of art production company Mindwalk marks Keywords’ fourth transaction in the last year and 11th since its July 2013 IPO. It has a track record of highly successful M&A to date with acquisitions being completed at attractive valuations and usually being immediately earnings accretive (with the sole exception of Kite Team). These acquisitions have helped Keywords to grow its revenues by 258% between 2013 and 2015, while at the same time growing normalised pre-tax profits by 216%. Details of the company’s most recent acquisitions include:

Kite Team (July 2015) added scale and bolstered South American Spanish capabilities:

Liquid Development (August 2015) furthered the company’s art production capabilities:

Ankama Asia (March 2016) established a base from which to build out capacity:

Mindwalk (March 2016) offered entry into the large Chinese market:

CEO Andrew Day was appointed in April 2009, having previously been CEO at interactive retail software developer Unipower Solutions. He was also head of retail and CPG for EMEA at NYSE-listed advanced analytics business FICO. He assumed the role from co-founder Giorgio Guastalla, who remains a non-executive director. Group Finance Director Andrew Lawton has extensive video games industry experience, having been a founding member of Sony PlayStation Europe and being a part of its growth up to $3bn in sales.

Where possible Keywords has a policy of keeping existing management in place post acquisition in order to ensure continuity and minimise any disruption that might arise during the integration process. Keywords then enhances the local delivery offering with a global sales, marketing and work allocation layer, which enables it to both grow local revenues and maximise asset utilisation by moving work around its studios to those with that are least capacity constrained.

To support its enlarged size and the increasingly global nature of its business, a new sales director was appointed last year to ensure that the sales effort is joined up, as part of an effort to bolster the management structure. The new management structure has been designed to be robust enough to support a much bigger business.

We view Keywords’ main sensitivities as follows:

Exhibit 3 shows Keywords’ key valuation multiples compared to its closest listed peers and the major listed games developers. Net cash at year end was €17.3m which is a substantial proportion (12%) of the £114m (€143m) market cap and therefore we believe the best multiples for comparative purposes are EV/EBITDA. On this basis Keywords is broadly in-line with SDL and at a premium to Lionbridge. It should be noted that Keywords benefits from significantly stronger growth than both companies, much of which is taking place in the higher margin art production service vertical. This is making direct comparisons with localisation peers less relevant overtime.

Although the games developers/publishers have a very different business model to Keywords we have shown them below as many benefit from the same underlying strong industry growth dynamic as Keywords and also to give an indication of their margins and the valuation attributed to them by the market. While the higher intellectual property inherent in the game development/publishing business tends to allow for higher margins and consequently higher valuations, this also come with a level of risk related to the hit driven nature of their revenues.

Despite its strong share price appreciation over the last year, Keywords’ multiple remains largely unchanged as its share price has broadly matched the rise in underlying business fundamentals and accretive M&A. We believe that despite Keywords completing a number of deals since its July 2013 IPO, the highly fragmented nature of the market offers the potential for further deals to be completed. We would expect these to be predominantly in the art production, audio production and community management service verticals, which we see as offering the most potential. The much larger size of the art production market in particular offers Keywords huge addressable growth potential with a favourable margin profile (c 45% gross margin vs c 35% blended group average). Keywords’ 2017e EV/EBITDA of 10.3x is slightly ahead of SDL, while we believe that it should trade at a greater premium given its high earning visibility, significantly stronger growth and robust M&A pipeline.

The fragmented nature of the video games industry means that there is still plenty of scope for further acquisitions. We expect that Keywords’ share price would respond positively to announcements of further deals, should they be at similar valuations to those that have been completed to date. Confirmation that the company is continuing to drive organic growth through successful cross-selling activity should also be viewed favourably by investors.

Keywords achieved revenue growth of 55% in FY15 including the contributions made by a number of acquisitions completed during the year. Underlying organic growth was still strong at c 20% as the company saw organic growth in all of its six service verticals as it successfully increased its penetration among its existing clients while also adding a handful of new ones. Keywords reports that it has seen a 70% increase in the number of clients that buy three or more services from it over the last year. This demonstrates that although Keywords already has an enviable client list, there is strong potential for it to increase its share of client spending.

As well as supporting the Keywords’ revenue growth, the aforementioned acquisitions have significantly diversified its revenue base by product offering. Overall these acquisitions should also be margin enhancing. Exhibit 4 provides a breakdown of Keywords’ FY15 revenues by service offering. Localisation (30%) and localisation testing (26%) remain the largest service offerings, however it is Keywords’ newer service offerings that are exhibiting strong levels of growth. Exhibit 5 provides a time series illustrating how we expect Keywords’ revenue split to develop. Despite not being part of Keywords’ product offering at the time of its IPO, we believe that art production could be the predominant service offering as early as 2017.

Keywords has already completed two acquisitions in 2016 and we expect further deals to be concluded before the end of the year. We have upgraded our FY16 revenue and profit forecasts to reflect growth from a higher 2015 base than we had previously forecast (€58.0m versus our €55.4m forecast), together with the impact expected from Mindwalk and Ankama. We now forecast FY16 revenues of €74.2m (up from €72.8m). We expect that the growing importance of the art production vertical together with increased scale will lead to successful margin expansion and we forecast Keywords’ adjusted operating margin to rise slightly from 14.1% in FY15 to 14.4% in FY17.

Keywords benefits from an extremely strong balance sheet, which was further bolstered by its November 2015 equity issue, which raised £10.5m gross (€12.5m) and left the company with €19.0m in cash as at the end of December 2015. The March 2016 acquisition of Mindwalk is expected to use c €3.5m and the early completion of the Kite Team acquisition will use a further €1m of this cash by mid-2016. Keywords’ underlying business is cash generative, and we expect net cash flow of €4.3m in FY16. This provides the company with ample cash with which to continue its buy and build strategy without the need for additional external funding at this stage.

Keywords paid a dividend of 1.21p (1.5c) a share in 2015, up 10% from 1.1p a share in 2014. This marks a continuation of management’s progressive dividend policy. While the present yield of 0.5% is not meaningful, its c 20% growth rate offers the potential for it to become more meaningful over time.