Keywords Studios — Update 13 September 2016

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, to the extent that it is now the largest provider of outsourced services to the games industry globally. The company provides services to 21 of the top 25 games companies by revenue and to seven out of the top 10 mobile games companies.

Acquisitions have meaningfully expanded Keywords’ span of coverage over the games development industry so far this year. For deals where metrics were disclosed, the total consideration payable was €26.5m (including shares and deferred considerations) at a blended valuation of 1.2x EV/sales and 8.0x EV/PBT.

The video games industry is predicted to grow at a compound annual growth rate (CAGR) of 7.9% between 2015 and 2018 (Newzoo, 2015). Keywords is growing more rapidly than this: c 20% organic in 2015 and we expect c 12% in 2016. This reflects a greater trend towards outsourcing as developers look for ways to reduce costs and increase flexibility by outsourcing the less creative parts of the development cycle. We also believe that Keywords is benefiting from economies of scale as games developers seek to use a progressively smaller list of trusted partners.

We believe that these scale benefits should enable Keywords to continue growing at a faster rate than the overall games industry and could strengthen as the company adds more components to its offering and invests in systems to improve synergies across the group:

Sales synergies – Keywords’ sales team operates (almost entirely) at a group level to facilitate cross-selling across the different product offerings, a process that may be enhanced by the implementation of salesforce.com later this year.

Strategic relationships – Keywords is already working on retained strategic relationships with two games developers within the localisation arena. In these relationships Keywords is the retained outsourced partner rather than operating on a project by project basis and the collaboration is a much closer collaboration. The company has ambitions to extend these initiatives, both in terms of adding new customers and adding new services.

Best practices and systems – While it is management’s approach not to over-manage its subsidiaries, to retain a customer-focused entrepreneurial spirit, forums are created to share insights and cross fertilise best-practices. The company is also selectively rolling out systems across divisions to improve the consistency, efficiency and oversight over the work being carried out.

Access to a larger talent pool – Much of Keywords’ work is highly seasonal and subject to strong peaks in demand particularly audio, localisation services and localisation testing. Keywords’ scale gives it access to a larger pool of contractors than many competitors, enhancing its ability to effectively support these peaks in demand. From a contractor’s perspective, Keywords is an attractive partner because it is able to provide more consistent, regular work than smaller competitors.

This year has seen both augmented and virtual reality games become a reality with phenomenal success of Pokemon Go and launches of VR headsets from Samsung, Oculus and HTC. Many developers are now developing VR/AR games and Keywords is working across all the VR platforms providing art, audio, QA and localisation services to support these activities. At present, we believe the short-term revenue opportunity for Keywords is fairly limited as most developments are at the early concept stage and the games available are single language and have only limited gameplay time. For example many of the VR games launched so far have only c 1 hour of game play time whereas 40+ hours is typical for an AAA console title, with some having well over 100 hours. Keywords’ revenue opportunity should expand significantly in the medium term as more games are localised for other geographies and as the games get bigger.

H116 revenues grew by 77% to €42.4m (H115: €23.9m), which is significantly ahead of what we would have expected, given our previous €85.8m full year revenue estimate and the fact that the business is usually second-half weighted. However, this is primarily because revenues for a number of major projects for the localisation and audio businesses, which both have summer activity peaks, fell into the first half of the year, whereas typically they are more H2 weighted. Included within this, the Synthesis group, acquired in April, enjoyed a particularly strong Q216. Most business lines performed robustly other than art (l-f-l revenues up 5%), where trading was somewhat quiet, but management has stated that business is now picking up strongly.

Overall H116 l-f-l revenue growth was reported to have been 30%, calculated on the basis of revenues being included for 2016 acquisitions from the date of acquisition and for the equivalent period in the prior year. The figure is flattered by the very strong performance from Synthesis in Q216 and we estimate the underlying organic growth rate was nearer 20%.

Our estimates assume c 12-13% organic revenue growth for the full year of 2016 and c 10% organic revenue growth in 2017.

Gross margin expanded to 35.1% from 34.4% in H1 last year, reflecting the increased contribution from high-margin (c 45%) Art Services from the Liquid Development and Volta acquisitions and strong utilisation rates in audio and localisation. We expect gross margins to expand slightly in H216 with further strengthening of the contribution from art offset by lower audio and localisation utilisation.

Normalised operating profit increased significantly to €6.1m (14.1% margin) from €1.8m in H115 reflecting the trading strength and operational gearing, but also good cost control and some benefit from centralising key functions. Historically, profit and margins have been much stronger in the second half-year, but we expect a much more even balance this year, reflecting the revenue weighting.

Longer term, we believe that a 14-15% operating margin is sustainable. While there may be opportunities to expand this through group level efficiencies, we believe that incremental margin is likely to be invested back into generating growth and capturing market share.

Net cash at the period end was €3.5m, down from €17.3m at December 2015, with a net cash inflow from operations of €0.6m more than offset by €13.7m of acquisition consideration and costs. Working capital requirements typically peak at the mid-year as the company builds operational capacity for the seasonal summer peak. H116 was no exception: the earlier than usual peak in summer revenues meant that much of the cash was still to be collected at 30 June. There was a working capital outflow of €4.4m (H115: outflow of €2.3m), which should reverse in the second half.

Keywords’ revenues and earnings are typically H2 weighted: out of the 2015 normalised PBT of €8.0m only €2.2m arose in the first half. However, with the peak in audio and localisation business occurring early this year (in Q216), we expect the H1 and H2 performance to be much more evenly balanced this year, with €6.2m of normalised PBT in H216e after the €6.0m in H116. We are nonetheless nudging our estimates for 2016 and 2017 upwards slightly (Exhibit 4) to reflect the good overall progress being made and continuing robust prospects and we believe that there may be scope for further upside.

Keywords’ shares have re-rated upwards following the recent rally to the extent that the company is now valued at the top end of its overall peer group (Exhibit 5). We believe that this premium rating is justified by the company’s strong strategic position and growth prospects. In the near term, further acquisition activity or a possible upgrade could bring the rating back into the pack. In the longer term, we believe that the company has a platform for generating sustained double-digit earnings growth through a combination of healthy organic growth and earnings-enhancing acquisitions.