Keywords Studios — Marching on

Keywords is the largest supplier of outsourced services into the global games development industry by some margin. Through consolidating a highly fragmented industry landscape, the group has built a unique portfolio of service lines which spans most of the games development cycle, from original concept through to go live. The company has a presence in most of the major games development city hubs globally and provides at least one service to all the main games developers globally.

Gaming has established itself as a mass-market media format, estimated to be worth over $100bn and growing at a 6-8% rate. We expect the market for outsourcing (estimated by Keywords to be worth c $5bn) to grow more rapidly than this (we estimate c 13%) as developers outsource more tasks to improve flexibility and focus on their core operations.

The company’s M&A strategy is supported by the very fragmented competitive landscape for service providers into the games industry. This has enabled Keywords to acquire focused studios at reasonable multiples and subsequently achieve synergies through cross-selling and/or cost efficiencies. The rationale for building scale is also supported by the structural imbalance between the games industry, which has consolidated substantially, and the fragmented service provider segment. The games industry’s shift away from hit-or-miss product sales to a much more recurring, franchise-based subscription model lends itself to retained multi-service engagements and Keywords is progressively developing strategic, multi-service relationships with a number of developers.

Keywords significantly strengthened its platform in FY17, with 11 acquisitions. Importantly, the group established a presence in engineering services with the acquisitions of GameSim, d3t and Sperasoft, enlarging the company’s estimated addressable market by c $1.5bn to c $5bn. The acquisition of VMC established the group as the leading global provider of functional testing services globally, expanding the company’s capability to include a global beta testing network and testing services embedded at the client’s site. Geographically, the company significantly strengthened its presence in the US (VMC, GameSim) and Russia (Sperasoft). Furthermore, the acquisition of four French companies has given the group strong capabilities across all major European languages for localisation and voice-over recording.

We estimate that FY17 acquisitions enhanced FY17 EPS by c 4c (17%) and FY18 EPS by 18c (60%) respectively. We estimate like-for-like growth in FY17 at a healthy mid-teen level, above the c 13% estimated for the games outsourcing industry, indicating Keyword’s scale and ecosystem are enabling the group to take market share organically as well as through acquisition.

Keywords has established a platform for generating strong, sustainable earnings growth. Through a combination of healthy organic growth and accretive acquisitions, we estimate that Keywords will generate a CAGR in sales, PBT and EPS of 75%, 76% and 52%, respectively, from 2013 to 2017 (see Exhibit 1). We expect a similar earnings growth trajectory from here. Considering the two largest acquisitions made in FY17, we understand the VMC integration is progressing well, and the company sees promising opportunities for Sperasoft. Factoring in the full year contribution from FY17 acquisitions and a conservative 7% organic growth, we forecast 52% EPS growth in FY18.

Future acquisitions should enhance EPS further. Management has stated that its acquisition pipeline remains healthy and the extent of fragmentation in the industry should continue to support the group’s M&A strategy for some time yet – especially with the entry into new segments such as Engineering. Available funds of €40m+ (FY17 net cash of €12.2m and a €35m debt facility), a c 90% cash conversion rate and a substantially higher rating than those of acquired companies all support the group’s ability to continue consolidating the market while enhancing earnings.

In Exhibit 2 we examine 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 €94m of cash in acquisitions between now and the end of FY18 (taking net debt/EBITDA to a relatively comfortable 2x level) and that these acquisitions are two-thirds funded by cash and one-third by equity at 1,488p (share price at time of writing). This suggests that if Keywords can maintain a low double-digit organic growth rate (vs healthy mid-teens in FY17) 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 70c+, 50% above our current FY18 EPS estimate. With additional capital from equity and in line with company’s acquisitive strategy, the cycle could then repeat into FY19.

The company’s rating of 39x FY18e earnings, dropping to 36x in FY19e, is a substantial premium to peers (average c 22x for FY18e), but additional acquisitions should bring these multiples down substantially and we believe our organic estimates are conservative. If we consider the scenarios portrayed in Exhibit 2, with good execution the company could exit FY18 rated at a mid-20s forward P/E. As the company executes its strategy over the course of FY18 investors should get better visibility of the higher level of earnings which are likely to be achieved and given the company’s long term earnings growth potential, we would expect the company to continue to trade at a premium to peers. Consequently, we believe that sustained execution should continue to drive robust returns for shareholders.

Keywords is the largest and most diverse supplier of outsourced services to the games industry by some margin. Through consolidating a fragmented industry landscape, the company has built a unique span of service offerings covering most of the games development cycle, from the original conceptual phase through to customer support, managed through seven service lines (see Exhibit 4). The company has 42 operational studios, located across 20 countries and four continents.

The company started its build-out strategy by acquiring positions in domains such as localisation, localisation testing, functional testing and audio, all of which are vital ancillary functions in the games development cycle. The company continues to strengthen its position in these services through acquiring companies with complementary skill sets, customers or geographical presence.

More recently the company has intensified its acquisition activity in domains that are closer to the core games creation process – particularly art (six acquisitions over the last 18 months) and now engineering (with the acquisitions of GameSim d3t and Sperasoft).

The games industry is growing at a healthy mid- to high single-digit rate and we believe that the market for outsourced services could grow at around twice this rate, driven by increased use of outsourced supply. We believe that Keywords is well placed to take market share, both organically – as business consolidates around larger players – and through further acquisitions, as the company consolidates an over-fragmented supply landscape.

Market analyst, Newzoo, estimates that 2.2 billion gamers globally will generate total revenues of $108.9bn in 2017, up 7.8% from $101.1bn in 2016, and forecasts a 6.2% CAGR through 2020. To put this into context, this is more than twice the value of global box office movie receipts – estimated at $38.6bn for FY16 and six times the size of the recorded music industry at $16.1bn, but still some way behind the Pay TV market of $207bn (with TV advertising revenue estimated at a further $183bn).

As an entertainment form, the medium is now truly mainstream, spanning all geographies and most demographics. Supported by the rise of mobile gaming, 41% of gamers are now female with the balance in mobile games c 50/50. The average age of a gamer in the US is now 35 while 63% of households are home to at least one person who plays video games.

Sizing the market for outsourced services is difficult, but Keywords’ management estimates that total spend on the services it offers is around $5bn pa, of which 50% is currently outsourced. The degree to which outsourcing has been adopted varies across service lines, but management estimates that, on a blended basis, this percentage will trend upwards towards 70% over the next five years (and higher over time). This would imply a CAGR of for the games outsourcing industry of c 13%.

The trend towards outsourcing is likely to be supported by a number of factors:

Supply chain disaggregation/adoption of leaner structures: vertically integrated industries typically disaggregate over time, stratifying into a supply chain of businesses with specialist marketing, production and creative/technical skills.

Keywords’ like-for-like revenue growth was 17% in H117 and we estimate that a similar rate has been maintained in H2. This is well above the games industry and higher than the low to mid-teens we estimate for the games outsourcing industry. This reflects both the sales leverage that Keywords is able to apply to its acquired companies and games developers consolidating their supplier base to improve efficiency and reduce costs.

Regardless of Keywords’ future acquisition activity, we believe it should continue to capture share from its smaller competitors, through its ability to offer:

Keywords has been the main driver of consolidation within the games service provider industry (Exhibit 9), and typically aims to make one or two larger strategic acquisitions each year supplemented by a number of small ones.

The market remains ripe for consolidation. Most service providers are subscale, revenues are dependent on a small number of customers and exit options are limited. A recent survey by the External Development Summit (XDS) of 150 developers found that 72% of service providers said they were open to being acquired.

Across the portfolio we believe there is plenty of headroom to continue building the platform for the strategy to continue. While recent acquisitions have put Keywords in a leadership position in some service lines – such as audio, localisation and localisation testing in certain markets, the addition of new service lines such as art, engineering and customer support opens up substantially larger markets. The company plans to add new service lines, with analytics high up the priority list.

We believe that Keywords has also developed a culture and methodology that have given the business a reputation as a good acquirer. Keywords identifies cultural fit as the most important screening criteria and teams are kept together, while benefiting from the group’s scale, market penetration, improved career prospects, processes /systems and financial stability in a games-focused group. Management reports that in certain segments the company is witnessing increased levels of inbound interest from companies interested in joining Keywords.

We are watchful for any signs of increased competition for key acquisition targets, but believe that these attributes will not be easy to replicate. We have seen sporadic acquisition activity from Keywords’ competitors such as Poletowin (2015 acquisition of Side, a UK-based voice and motion capture specialist) and Virtuos Games (2017 acquisition of Black Shamrock, an Irish role play games and strategy specialist). However, we have yet to see any evidence that any of these have plans to engage in a more expansive acquisition strategy. Sumo, a UK-based engineering and art competitor, which recently listed on AIM (£38m raise, £40m vendor placing), acquired Atomhawk, a UK-based art studio in July 2017 for an estimated £2.3m.The company has also cited acquisitions as an element of its strategy. It is possible that outsourcers from outside of the gaming industry look to expand into this vertical through acquisitions, but as yet we have yet to see any significant activity and replicating Keywords’ successful formula may be challenging for players outside the industry.

Keywords targets a 15-30% ROI from acquisitions within two to three years. This starts with maintaining good price discipline, supported by the attributes described above and a fragmented competitive landscape. Valuations averaged c 1x sales, while the average EV/PBT multiple was 7.2x for FY15 and FY16 based on the estimated run rate at the time of acquisition. We estimate the ytd average for FY17 is higher at 11.3x, as a result of the VMC and Sperasoft acquisitions, but both were larger and strategically important, while the multiples of both should be brought down to the 7x level over the next two years as margins are expanded to the group c 15%+ level.

When acquiring, management’s key focus is on achieving margin expansion via insertion into the Keywords ecosystem rather than compared against the historic margin performance. Most acquisitions are expected to achieve margins close to the group level (15.5%) within two years. In the longer term, a number of studios have successfully leveraged Keywords’ platform to significantly increase scale through international expansion and customer acquisition.

2017 was the company’s most active yet, with 11 acquisitions completed for a total €99m consideration (of which €89.1m was cash). In aggregate we estimate these acquisitions boosted run rate sales, PBT and EPS by €91m, €9m and 11.5c respectively, while significantly strengthening the company’s platform in a number of areas.

The company initiated its long-mooted entry into the engineering service line with the acquisition of Orlando-based GameSim for $4.8m in May 2017. This was then followed up with the £3m acquisition of UK-based d3t in October and most recently with the €22m ($27m) acquisition of Sperasoft in December 2017, which also gave Keywords a footprint in Russia, through which it plans to establish new service lines in the region. Management estimates that the engineering services market is worth circa $1.5bn, expanding Keywords’ total addressable market to $5bn.

The addition of engineering capability, together with the strengthened Art service line (four acquisitions over the past 24 months) has significantly strengthened the company’s offering of higher value-added services that are closer to the core operations of games developers. The acquisition of Sperasoft was particularly significant in this regard, due to its operation of a “co-development” model with key customers, whereby the studio is engaged on a more holistic basis to develop complete elements of a particular title. Management is likely to seek to roll out this model on a broader basis across the group.

The $66m acquisition of VMC in October 2017 NYSE-listed outsourcer, Volt Information Sciences (VISI:NY), was Keywords’ largest ever and significantly strengthened the group’s presence across functional testing, customer support and localisation testing services. It also gave the company offices in Redmond, WA and Montreal, Canada, both prime locations for the games industry, while it has others across the US and Canada, employing 1,300 staff either directly or indirectly.

Strategically, the deal enhanced the group’s platform in two particular ways:

VMC has a well-established technical services business whereby its staff are embedded in the client’s sites (for the most part, Keywords’ services are delivered from its own offices), providing a broad range of testing and customer support solutions. Thus the acquisition is seen as an important addition to Keywords’ longstanding drive to develop deeper, multi-disciplinary strategic relationships with clients.

VMC’s Global Beta Testing Network (GBTN) is a vetted group of private individuals who test games using their home devices shortly before a game is launched - essentially replicating a real world environment in terms of volume of users, home technology/telecoms set-up, geography etc. Keywords had been developing its own capability in this field, but this acquisition accelerates the build out and gives it significantly more scale and expertise.

Keywords’ management sees strong opportunities for cross-selling this service to its global client base. In particular, the GBTN is seen as a key element of an end-to-end risk management solution, which is under development. The proposed service will combine services from Keywords’ Player Research (mid/early in the games development cycle), testing (mid/late in cycle) and the GBTN (late cycle) to help ensure quality control and user experience are built in throughout the development cycle. Other areas of interest include data science, predictive analytics and AI, and pipeline automation.

Unlike some of Keywords’ other recent acquisition, VMC’s recent performance had been lacklustre. Run rate revenues were $58.1m, broadly flat year-on-year (when stripping out two discontinued large, low-margin contracts) and adjusted operating margins at 9.1% are well below Keywords’ 15.5% (FY16). Management expects to reinvigorate top-line, through cross-selling and margin performance through progressively releasing $2.5m of savings over the next two years. We understand that good progress is being made with the integration so far.

The business was acquired for $66m (c €56m), funded by a cash placing of £75m (€85m) gross leaving the group with €25m+ of surplus for future acquisition activity (of which circa €19m has since been used in the acquisitions of Sperasoft and LOLA).

Factoring modest 5% revenue growth and cost savings of $1.5m in FY18, we estimate that the deal will enhance adjusted EPS by c 8c for FY18, with more to follow in FY19 as the remaining $1m cost savings come through.

As Keywords’ portfolio expands, so does its ability to cross-sell. The company now derives 80% of its revenues from 84 clients who use more than three of the group’s services and, while acquisitions have clearly also contributed to these figures, cross-selling has been a major contributor as well. The company provided a number of successful cross-selling examples at the recent investor day, two of which are highlighted in Exhibit 11.

As the game industry shifts away from hit-or-miss product sales to a much more recurring, franchise-based subscription model, so the service model lends itself to retained multi-service engagements rather than tendering for work on specific titles. We believe that Keywords is clearly in pole position to win a significant proportion of this business.

Management describer three levels of retained service. As the company executes its strategy we would expect the number of clients at each level to grow.

Adding to this, as the portfolio expands, Keywords’ ability to offer joined up solutions covering a number of distinct elements of the games development process strengthens. As previously discussed, the acquisition of VMC was seen as a key component to enable the group to develop an end to end risk management solution spanning player research, testing and beta testing. In Art, the company enhanced its pre-production, concept art capability with the 2016 acquisition of Volta and cross-selling synergies between Art and Engineering are particularly strong. Within localisation, in Exhibit 11 we describe the migration of a client from a single service (localisation test) to a strategic end-to-end service, increasing revenues from the client 600% over this time.

It is difficult to see any one factor that would significantly compromise Keywords’ progress, although the high multiple leaves little margin for error and setbacks could significantly dent the share price.

Acquisitions: Keywords’ strategy and track record of making earnings-enhancing acquisitions and providing a platform for these businesses to perform well is key to the investment case. The success of this strategy hinges on the company’s ability to select the right acquisitions, maintain price discipline and retain a reputation as a good acquirer and employer. While an acquisition strategy does bring inherent risk, each target is relatively small compared to the overall group, reducing the risk of any one acquisition significantly affecting results.

Games industry growth: the games industry has been enjoying strong structural growth for some time now. In FY16 growth outstripped expectations entering the year and while we believe that this structural growth should be set to continue, we add the caveat that it is difficult to estimate how trading has been boosted by particularly buoyant near-term conditions.

Interest rates and stock market rating: the current macro environment is very supportive for Keywords to execute its acquisition strategy, with low interest rates and stock market valuations. This tailwind would moderate somewhat if interest rates were to rise and the stock market/ Keywords’ stock de-rated.

Foreign exchange risk: Keywords operates a number of offices around the world and generates revenues in multiple currencies and it is therefore exposed to exchange rate risk.

Scale/rating: pressure on management to pursue a more aggressive strategy could increase as companies grow in scale or re-rate upwards. This can deliver accelerated upside but also increases risk.

Key person exposure: we believe that Keywords’ share price and potentially its operations could be affected by the loss of key management, particularly Andrew Day, CEO.

Through a combination of healthy organic growth and accretive acquisitions, we estimate that Keywords will generate a CAGR in sales, PBT and EPS of 75%, 76% and 52%, respectively, from 2013 to 2017. With the full-year contribution the acquisitions made in FY17, we forecast a further 56% normalised EPS growth in FY18, even in the absence of further acquisitions and estimating a conservative 8% like-for-like growth.

In Exhibit 12 we show how consensus FY17 and FY18 sales and EPS estimates have progressed over the past 12 months as a result of organic growth and accretive acquisition.

With a healthy industry backdrop, a strong competitive position and ongoing execution of the acquisition strategy, we expect strong growth to continue.

Our P&L model is shown in Exhibit 13. The recent trading update stated that FY17 revenues would be at least €150m, implying like-for-like growth in the healthy mid-teens, vs 12% in FY16 and 17% in H117 (28% if adjusting for last year’s exceptionally strong trading at the audio business). Conservatively, we forecast 7.3% like-for-like growth in FY18 and 8.0% FY19, but believe there is clear scope for upside.

We are forecasting a slight compression in operating margin (15.1% from 15.3%) to reflect the VMC acquisition and increased investment to support growth. This investment includes expanded office space in Montreal, Tokyo and Dublin. The company has also bolstered its IT and HR teams and hired M&A and tax specialists to strengthen the group’s platform. VMC was generating 9.1% operating margins on acquisition, but restructuring and synergies are expected to bring these in line with the group level within two years.

Looking longer term, we believe there may be scope for margins to expand above the level forecast if the company can build scale and diversity in Art and Engineering or secure more strategic outsourcing deals, although management may choose to invest any incremental gains back into growing the business.

We also forecast a progressive reduction in the tax rate over the period as the company leverages its diverse geographical footprint to improve tax efficiency.

The company ended the year with net cash of €12.2m, comprising €30.5m in cash and €18.3m in debt utilised from a €35m rolling credit facility.

The group generates robust cash flows. Working capital demand are relatively modest, although seasonality means that cash inflows are typically H2 weighted, with a trough at mid-year. We are forecasting a near term increase in capex to fund office consolidation and modernisation, but remaining at a very manageable level.

The company’s robust cash generation and balance sheet give the group at least €40m of resources to continue making acquisitions in FY18. We believe that the company’s diverse revenue streams and cash flow generation profile could comfortably support an increase in net debt to the 2x EBITDA level, or c €94m by year-end 2018. Raising funds through equity is clearly also an option.

The figures above clearly only incorporate acquisitions made so far. While it is impossible to forecast future acquisitions with any accuracy, the earnings accretion driven by future acquisitions is clearly core to Keywords’ investment case.

In Exhibit 2 we examine 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 €94m of cash in acquisitions between now and the end of FY18 (taking net debt/EBITDA to a relatively comfortable 2x level) and that these acquisitions are two-thirds funded by cash and one-third by equity at 1,488p.

We point out that this analysis is for illustrative purposes and not a forecast. However, it does suggests 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 70c+, 50% above our current FY18 EPS estimate. With additional capital from equity and in line with company’s acquisitive strategy, the cycle could then repeat into FY19.

The key attraction of Keywords’ business model and investment case is the fact that the company can continue generating robust double-digit earnings growth without deviating from its current strategy or expanding beyond its core games developer customer base.

The company’s rating of 39x FY18e earnings, dropping to 36x in FY19e, is a substantial premium to peers (average c 22x for FY18e), but acquisitions should bring these multiples down substantially. Our like-for-like growth estimates are also conservative (8% for FY18e and FY19e). The company’s price/earnings growth ratio (PEG) for FY16/18 is 0.8x, a discount to peers, indicating that if the company can sustain a similar EPS growth trajectory, the shares could appreciate further.

If we consider the scenarios portrayed in Exhibit 15, using very reasonable assumptions, the company can more than double EPS from our FY17 estimated level entering 2019, in which case it would be rated at a mid-20s multiple. With plenty of financial headroom to continue executing its current strategy, Keywords’ earnings growth potential should look equally strong looking into 2019 and beyond. Consequently we would expect the company to continue to trade at a very healthy growth multiple. With successful execution of its strategy over the course of FY18, we would therefore expect the company’s future EPS growth potential to become more fully priced in. Consequently, we believe that sustained execution should continue to drive robust returns for shareholders.