Keywords Studios — Reassuring CMD, residual concerns dispelled

The capital markets day in Montreal in November 2019 focused on the benefits of scale, cross-selling and the integration of new studios into the ‘family’. For the London CMD, Keywords focused on the opportunities for the different service lines, highlighting the higher value-added service lines, development and art services (including marketing services, which will be broken out when it reaches €30m). Management has been clear that this is where Keywords is likely to focus its future M&A activity to drive growth.

Andrew Day (CEO) and Jon Hauck (CFO) bookended the presentation, with the stage largely left to representatives of the different service lines as well as studio heads in development and marketing services. This showcased the company’s collaborative approach and helped to underline that Keywords is not overly centralised, and that there is broad buy-in to the ‘family’ values that the management team espouses, with teams and studios ready and willing to work together to deliver broad-based client solutions. Following an acquisition, Keywords seeks to remove the administrative burden from the studio, to allow them to do what they have done, only better.

Jon Hauck closed the day with a presentation providing further clarification on the recent trading update, particularly dealing with concerns around margin progression as well as cash conversion. Wrapping up, Andrew Day reiterated his view of the growth prospects for the firm, with increased development budgets ahead of the Q420 console transition likely to benefit Keywords in FY20, and the increase in new releases expected in FY21 and beyond as the next-gen user base builds (with current-gen running in parallel with next-gen) set to benefit Keywords in the medium term.

In FY19, Keywords has been investing in its platform and capacity to ensure that it can deliver its suite of services, with a similar level of professionalism, to clients wherever they are based, with services fronted by a local team, but deliverable on a round-the-clock, distributed basis to meet client needs. The next step for Keywords is to demonstrate to even the largest, most demanding AAA clients that it now uniquely has the scale to be a professional and reliable partner.

The clear message from the CMD is that management feels that the successful model it has built with Keywords has a lot further to run. In FY19, the company experienced some growing pains, which meant it had to pause growth in certain service lines (eg Player Support) and invest ahead of the curve to build out the facilities, teams, management and technology platforms to allow for sustainable future growth. However, this investment is now set to support sustained scale and growth over the course of FY20 and beyond.

Keywords committed €13m to eight acquisitions in FY19 (it expects to complete six to 10 deals annually), and there was confirmation that VMC, which had dragged on results in FY18 and FY19, is finally starting to deliver on its promise. VMC, acquired in October 2017, was the company’s largest acquisition and was bought to build scale for the localisation and QA service lines in North America. Management recognised that VMC needed restructuring, but with the scale and market presence that it has delivered, Andrew Day suggested that it might now provide a model for the expansion of these service lines in Europe, India and Asia.

In FY19, Keywords delivered 30% revenue growth and 15% underlying organic growth. Underpinned by strong industry growth (Newzoo: 8.4% CAGR 2019–22), this level of growth looks set to continue – we forecast FY20 revenues of €374.9m (+15% y-o-y, +12% on FY19 closing ARR). Adjusted operating margins are set to improve through FY20 to c 15% so for FY20 we forecast an average operating margin of 14.2% (FY20 EBITDA of €61.2m, operating income of €53.4m) and normalised EPS of 64.8c, a 41% uplift on FY19. This is before factoring in any incremental contributions from M&A.

As we have noted previously, Keywords benefits from the trend towards outsourcing, increasing market share as a market leader in a fragmented global industry with growth further supplemented by a proven M&A model. With the next console transition in Q420, the short- and medium-term growth outlook remains robust.

Management highlighted that FY19 had also been a year of investment in the business and capacity (for example, the investment in the Montreal studio) and given that clients tend to share their release roster with Keywords 12 months ahead for planning purposes, Keywords has an excellent view of the pipeline of work through the console transition and beyond. Noting a number of announcements in H219 that major AAA releases have been delayed (Ubisoft, CD Projekt – CyberPunk), it is worth noting that even if games that Keywords is working on are delayed, this will usually mean an extended project with extra work for Keywords.

In FY19, Keywords invested in its platform and capacity to ensure that it can deliver its suite of services, with a similar level of professionalism, to clients wherever they are based, with services fronted by a local team, but deliverable on a round-the-clock, distributed basis to meet client needs.

To do this and demonstrate its capacity to deliver for clients at scale, Keywords felt that it had to build facilities in order to generate the demand to fill those facilities. Larger clients will only be comfortable placing major projects with Keywords if they can first see the assets – the facilities, staff and technology – to deliver a successful project.

To reinforce the benefits that increasing scale delivers, Keywords highlighted the barriers to entry that increase as the group scales:

Since its IPO in 2013, Keywords has delivered average annual organic growth of 15% and an overall revenue CAGR of 65%. As can be seen in Exhibit 2, even with this strong growth, management has managed to build and maintain a diversified business that remains balanced across its seven service lines.

Keywords’ buy and build model has served it well since the company’s IPO, helping to deliver over €200m of additional revenues with 46 acquisitions across 16 countries. In a typical year, Keywords expects to make six to 10 acquisitions (2019: €13m across eight deals, +€15m of deferred consideration from 2018) and has so far managed to maintain price discipline, having paid an average ~1.2x revenue multiple historically.

The key point to note is that Keywords is not bulking up, seeking size for size’s sake, but rather is building out a global service proposition with business lines of appropriate scale to deliver consistency. Local offices hold the client relationships, regional hubs help to ensure consistency of offering and delivery across all major service lines, together with global specialists able to offer niche services to meet the client’s specific needs. Examples cited included Sperasoft’s work on Assassin’s Creed, Electric Square working with Microsoft on Forza Street and the Trailer Farm’s round-the-clock work for Gearbox on Borderlands 3.

Keywords is also building out an operating framework and IT infrastructure to support distributed service delivery, seamlessly pulling together teams and studios from separate locations to deliver client projects professionally.

Finally, it is worth highlighting that each of the various studios represented at the CMD felt that they had made the right decision to sell to Keywords. As small studios, joining a large company meant they no longer needed to rely on constantly finding the next project and could now concentrate on what they enjoyed most, working with and delivering for their clients. In addition, the Keywords family provided access to a greater pool of resource and expertise, meaning they could work on bigger, more challenging projects and draw on specialists from around the group when needed.

Each business line has its own growth proposition, but future M&A, although opportunistic, is likely to be concentrated on higher-margin business lines, with Development and Marketing Services highlighted in particular. For example, Keywords discussed the spectrum of development expertise (Exhibits 5 and 6) where, historically, Keywords’ delivery has been based around lower-margin engineering and porting work. However, as studios build experience and establish their reputation, they are increasingly pushing into higher-margin co-development and full development projects.

Despite this progression towards higher-margin projects, management was very clear that studios are not aiming to take revenue share. The Keywords model is built on a cost plus approach with any revenue share expected to be marginal (eg to ensure an alignment of interest with the client), rather than to exchange development fees for potential future upside.

Opportunistic acquisitions in other service lines remain likely and, in particular, Andrew Day suggested that the VMC acquisition (offering localisation and quality assurance (QA) scale in North America) might provide a model for expansion in Europe, India and Asia.

In terms of approach, Keywords conducts its own due diligence, avoids auctions and has maintained rigorous price discipline to date (we estimate recent deals at 1.5–2.0x sales and a long-term average ~1.2x revenue multiple). These low multiples are achievable because Keywords tends not to compete with other buyers – developers and publishers normally look to acquire IP and content, whereas Keywords is primarily seeking service competence and is not interested in IP.

To help explain the margin erosion seen in the unaudited FY19 figures, Jon Hauck explained the bridge in Exhibit 7, accounting for the EBITDA margin changes between FY18 and FY19.

FY18: 17.4% EBITDA margin

FY19: 15.2% EBITDA margin

Jon Hauck also reconciled the cash flow to highlight that underlying cash conversion was comparable to prior periods. The principal normalisation adjustments were:

The full (unaudited) reconciliation is shown in Exhibit 8 below. This is compared to normalised PAT of €30.7m (FY18) and €33.4m (FY19) to show that the underlying cash conversion had improved marginally from 84% in FY18 to 85% in FY19.