Keywords Studios — Strong trading update and acquisition of gnet

Keywords Studios (LN: KWS)

Currency in

Last close As at 25/09/2023

50.00 (1.74%)

Market capitalisation

2,207m

Research: TMT

Keywords Studios — Strong trading update and acquisition of gnet

In its trading update, management confirmed that adjusted FY20e PBT is expected to be c €52m, a 27% increase y-o-y and 12.7% ahead of our prior estimate, with revenues of €367m, 0.5% ahead of our prior estimate. FY20e margins of 14.2% vs 12.5% in FY19 are driven by improved operational leverage and tight cost control, together with COVID-19 related cost reduction (eg marketing, travel). Having pared back our forecasts at the start of the COVID-19 pandemic, we now upgrade our FY20 estimates for a second time to reflect the significantly stronger margins in H220e, raising our FY21 estimates and introducing our FY22 estimates. We have also incorporated the US$32m acquisition of the LA-based marketing services business, gnet. With substantial financial resources following its £100m placing in May, management remains focused on its M&A agenda.

Richard Williamson

Written by

Richard Williamson

Director, TMT

TMT

Keywords Studios

Strong trading update and acquisition of gnet

Trading update

Software & comp services

26 November 2020

Price

2,204p

Market cap

£1.63bn

€1.13/£

Net cash (€m) at 30 June 2020 (excluding lease liabilities)

101.0

Shares in issue

73.96m

Free float

90%

Code

KWS

Primary exchange

AIM

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(0.3)

(0.5)

55.2

Rel (local)

(8.5)

(7.1)

75.7

52-week high/low

2,306p

1,232p

Business description

Keywords Studios is the largest and most diverse supplier of outsourced technical and creative services to the games industry. Through regular acquisitions, the company is building its scale, geographic footprint and delivery capability to become the ‘go-to’ supplier across the industry.

Next event

FY20 trading update

January 2021

FY20 results

March 2021

Analysts

Richard Williamson

+44 (0)20 3077 5700

Dan Ridsdale

+44 (0)20 3077 5700

Keywords Studios is a research client of Edison Investment Research Limited

In its trading update, management confirmed that adjusted FY20e PBT is expected to be c €52m, a 27% increase y-o-y and 12.7% ahead of our prior estimate, with revenues of €367m, 0.5% ahead of our prior estimate. FY20e margins of 14.2% vs 12.5% in FY19 are driven by improved operational leverage and tight cost control, together with COVID-19 related cost reduction (eg marketing, travel). Having pared back our forecasts at the start of the COVID-19 pandemic, we now upgrade our FY20 estimates for a second time to reflect the significantly stronger margins in H220e, raising our FY21 estimates and introducing our FY22 estimates. We have also incorporated the US$32m acquisition of the LA-based marketing services business, gnet. With substantial financial resources following its £100m placing in May, management remains focused on its M&A agenda.

Year end

Revenue (€m)

PBT*
(€m)

EPS*
(c)

DPS
(p)

P/E
(x)

Yield
(%)

12/18

250.8

37.9

45.5

1.61

54.7

0.07

12/19

326.5

40.9

48.8

0.58

51.1

0.03

12/20e

367.0

52.0

58.0

0.00

42.9

N/A

12/21e

433.6

61.6

65.3

1.91

38.2

0.09

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

FY20e: Operational leverage drives margin growth

Based on the provisional figures, H220e has been considerably stronger than H120, with 12% y-o-y revenue growth delivering FY20e revenues of €367m. H220e adjusted PBT of €30.3m, vs €21.7m in H120, suggests 35% y-o-y adjusted PBT growth vs H219 and an adjusted PBT margin of 15.7% versus 12.5% in H120. The adjusted PBT margin for FY20e as a whole is expected to be 14.2%. The anticipated improvement in margins in H220e vs H120 is due to improved operational leverage on the back of higher revenues (€193.5m implied in H220e vs €173.5m in H120) and tight cost control.

Revised FY21 and introduction of FY22 estimates

Our revenue estimates for FY21 rise by 5.1% to €433.6m, incorporating the revenue from the acquisition of gnet and a 12% increase on FY20e, and we have introduced an FY22 revenue forecast of €485.7m, a further 12% increase as industry growth is set to continue. Reflecting the stronger than expected adjusted PBT in FY20e, we raise our FY21e forecast margin to 14.2% (FY20e: 14.2%), rising further to 14.6% in FY22e. We leave our gross margins at 37.6% in FY21e, rising slightly to 37.9% in FY22e and expect a resumption of Keywords’ progressive dividend policy in FY21.

Valuation: US$32m gnet deal, further M&A expected

Keywords’ shares trade on a P/E of 42.9x our updated FY20e estimates, falling to 38.2x in FY21e, having incorporated gnet into our model. With substantial net cash as well as €100m of undrawn facilities, management’s growth strategy, supplemented by M&A (which has delivered a five-year EPS CAGR of 42% to FY19), appears sustainable and should continue to support the shares.

Revised FY20–21 and introduction of FY22 estimates

We had expected Keywords’ business to bounce back relatively quickly once global lockdowns eased (as was seen by its Chinese studios), supported by pent-up demand from its core client base wishing to keep major projects on track and underpinned by strong consumer demand for games across all platforms and geographies. However, we have been positively surprised by the speed of the recovery and, with strengthening margins, the growing potential for cross-selling across service lines and sector growth driven by demand from an increasing consumer base of next-generation consoles, we expect to see a return to trend growth in FY21–22.

Based on the provisional figures released in Keywords’ trading update, H220e has been considerably stronger than H120, with 12% y-o-y revenue growth delivering FY20e revenues of €367m. However, importantly, with implied H220e adjusted PBT of €30.3m vs €21.7m reported in H120, this translates into 35% y-o-y (H220e vs H219) adjusted PBT growth and an adjusted PBT margin of 15.7% in H220e versus 12.5% in H120. The adjusted PBT margin for FY20e is therefore expected to be 14.2%.

The improvement in margins in H220e vs H120 firstly reflects margin compression due to COVID-19 related disruption and a resulting revenue shortfall in H120, with far less disruption experienced in H220. Together with improved operational leverage, on the back of higher revenues (€193.5m in H220e vs €173.5m in H120) and tight cost control, this has meant that the H220e results have also benefited from COVID-19 related reductions in operating expenditure, including direct costs such as travel, conferences and marketing. We understand that there has been no material change in business mix in FY20.

Despite a trend of strengthening margins, for the reasons set out above, we see the elevated 15.7% adjusted PBT margin in H220e as unlikely to be sustained in FY21. With more normal levels of capex, marketing spend and travel expected in FY21, we currently anticipate profitability to build from the blended 14.2% margin forecast for FY20e; as such, we estimate 14.2% adjusted PBT margins for FY21e.

Exhibit 1: Revised estimates

€'000s

2019

2020e

2021e

Y-o-y

change

2022e

Y-o-y

change

Year end 31 December

Actual

Old

New

Change

Old

New

Change

new

Revenue

326,463

365,056

367,011

0.5%

412,461

433,643

5.1%

18%

485,680

12%

Gross profit (inc multimedia tax credits)

120,229

138,021

138,649

0.5%

153,868

162,989

5.9%

18%

184,031

13%

Gross margin (%)

36.8%

37.8%

37.8%

37.3%

37.6%

37.9%

EBITDA (adjusted)

57,611

64,066

69,910

9.1%

77,560

83,518

7.7%

19%

94,796

14%

Operating profit (pre amort. and except.)

42,983

49,677

55,521

11.8%

56,939

64,118

12.6%

15%

73,296

14%

Operating margin

13.2%

13.6%

15.1%

13.8%

14.8%

15.1%

Profit before tax (norm)

40,913

46,177

52,021

12.7%

53,439

61,618

15.3%

18%

70,796

15%

PBT (norm) margin

12.5%

12.6%

14.2%

13.0%

14.2%

14.6%

Profit after tax (norm)

33,451

37,755

42,533

12.7%

43,693

50,380

15.3%

18%

57,884

15%

EPS – normalised (c)

48.8

51.5

58.0

12.6%

56.4

65.3

15.7%

13%

75.3

15%

Dividend per share (p)

0.58

0.00

0.00

1.95

1.91

(1.8)%

-

2.11

-

Source: Keywords Studios accounts, Edison Investment Research

Introduction of FY22 forecasts

Although Keywords is a service provider to the games industry and has not benefited directly from lockdown, unlike the digital games publishers, its future growth is still supported by strong and continuing games industry growth. Newzoo’s latest forecasts (November 2020) imply 10.5% games industry growth globally between 2019 and 2023, with the games industry forecast to deliver global revenues of US$175bn in 2020, continuing to grow to US$218bn in revenues by 2023.

Revenues: our revenue estimate for FY21e has risen by 5.1%, incorporating the revenue from the acquisition of gnet and a 12% increase on FY20e. Supported by continuing industry growth, we have assumed 12% revenue growth in FY22. These levels of growth represent a degree of catch-up from FY20e, leading to FY21e revenues of €433.6m and FY22e of €485.7m.

Margins: management has guided towards adjusted PBT margins normalising towards the end of FY21e, versus 14.2% for FY20e. Therefore, we are using what we believe to be relatively conservative 14.2% margins for FY21e, rising to 14.6% in FY22e. We assume gross margins of 37.6% in FY21e (broadly flat vs FY20e), rising marginally to 37.9% in FY22e.

Tax rate: through effective planning, Keywords’ tax rate has reduced steadily from 22% in FY16 to 18.2% in FY19. We assume this level is sustained and forecast a tax rate of 18.2% in FY21 and 22.

We have also assumed that tax credits – the Multimedia Tax Credit (MMTC – Canada) and the Video Games Tax Relief (VGTR – UK) – grow at 10% in FY22.

Capex: Keywords put a temporary hold on discretionary capex spending during the COVID-19 pandemic, and we expect capex to normalise in FY21 and FY22. On this basis, we forecast capex to return to 4.0% of revenue in FY21 and FY22, €17.5m and €19.6m respectively.

Dividend: the final dividend for FY19 was cancelled with the onset of COVID-19, meaning that the total dividend payable for FY19 was 0.58p. We do not expect Keywords to pay an FY20 dividend but rather, given the company’s statement in September that the board remains committed to resuming its progressive dividend policy in 2021, we expect a resumption of its progressive dividend policy with the FY21 interim dividend, assuming 10% growth over our estimate for the FY19 full-year dividend prior to the spring 2020 lockdown. This implies a total FY21 dividend of 1.91p per share (FY18: 1.61p, FY19: 0.58p, FY20: 0.0p). We assume continuing 10% y-o-y dividend growth for FY22.

M&A: US$32m acquisition of gnet, more to come in FY21

By its nature, the timing of acquisitions can be hard to predict, but hot on the heels of Keywords’ trading update came the announcement of the acquisition of g-Net Media (gnet), a Los Angeles-based creative and strategic marketing services business for up to US$32m in cash and shares.

Management expects gnet to deliver revenues of US$20m and EBITDA of about US$3m in FY21, implying a 15% margin (broadly in line with Keywords). With US$18m payable upfront (56% of total potential consideration), of which US$14.4m is payable in cash, the initial consideration represents 0.9x expected FY21e revenues (year to 31 December 2021) and 6x FY21e EBITDA. The remaining consideration of US$14m (44% of the maximum) is performance related and payable on the first and second anniversary of the deal in a mix of cash and shares. The acquisition has been factored into our model, but given its timing shortly before Thanksgiving and the seasonally light month of December, we do not envisage any material contribution to Keywords’ FY20 revenues or PBT.

The gnet deal is one of Keywords’ larger and more expensive (as would be expected for a US West Coast-based deal) recent acquisitions but is in line with management’s stated M&A strategy and consistent with other recent acquisitions in supplementing Keywords’ marketing and development capabilities (similar to the other three deals completed in FY20). The acquisition of gnet looks like a sensible deal that will strengthen Keywords’ marketing capabilities and deepen its relationships with games publishers including Activision, Microsoft, Bethesda and Bungie, as well for media companies such as Netflix, Amazon Prime and NBC Universal.

Keywords’ strategy of using earnings-enhancing acquisitions while consolidating a fragmented market is intrinsic to the investment case. Management has stated that the acquisition pipeline remains strong and that it continues to receive healthy inbound interest from around the world. With substantial financial resources following its £100m placing in May, as well as undrawn committed facilities of up to €100m, the company retains considerable firepower for further M&A. As we do not incorporate future acquisitions into our forecasts, M&A activity represents a source of potential upside to our earnings estimates.

Exhibit 2: Financial summary

€'000s

2018

2019

2020e

2021e

2022e

Year end 31 December

IFRS

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

 

250,805

326,463

367,011

433,643

485,680

Cost of Sales

(154,997)

(206,234)

(228,363)

(270,655)

(301,649)

Gross Profit (inc multimedia tax credits)

95,808

120,229

138,649

162,989

184,031

EBITDA (adjusted)

 

 

43,729

57,611

69,910

83,518

94,796

EBITDA (reported)

 

 

34,304

43,375

60,198

71,690

81,786

Operating Profit (before amort. and except.)

 

 

38,916

42,983

55,521

64,118

73,296

Amortisation of acquired intangibles

(6,872)

(7,318)

(11,324)

(13,505)

(15,125)

Exceptionals

(5,296)

(4,348)

(2,370)

0

0

Other (incl share based payments)

(4,129)

(9,775)

(10,753)

(11,828)

(13,011)

Operating Profit

22,619

21,542

31,074

38,785

45,160

Net Interest

(1,316)

(2,513)

(3,500)

(2,500)

(2,500)

Forex

791

(1,658)

0

0

0

Profit Before Tax (norm)

 

 

37,911

40,913

52,021

61,618

70,796

Profit Before Tax (FRS 3)

 

 

22,094

17,371

27,574

36,285

42,660

Tax

(7,191)

(7,462)

(9,488)

(11,238)

(12,912)

Profit After Tax (norm)

30,720

33,451

42,533

50,380

57,884

Profit After Tax (FRS 3)

14,903

9,909

18,086

25,047

29,748

Average Number of Shares Outstanding (m)

64.3

65.1

69.6

74.1

74.3

EPS - normalised (c)

 

 

45.5

48.8

58.0

65.3

75.3

EPS - normalised fully diluted (c)

 

 

43.7

47.2

55.8

63.1

73.0

EPS - (IFRS) (c)

 

 

23.2

15.2

26.0

33.8

40.0

Dividend per share (p)

1.61

0.58

0.00

1.91

2.11

Gross Margin (%)

38.2%

36.8%

37.8%

37.6%

37.9%

EBITDA Margin (%)

13.7%

13.3%

16.4%

16.5%

16.8%

Operating Margin (before GW and except.) (%)

15.5%

13.2%

15.1%

14.8%

15.1%

PBT Margin (%)

15.1%

12.5%

14.2%

14.2%

14.6%

BALANCE SHEET

Fixed Assets

 

 

198,215

223,992

231,673

232,769

234,260

Intangible Assets

180,086

196,769

202,978

196,513

188,848

Tangible Assets

15,002

22,163

23,636

31,196

40,352

Investments

3,127

5,060

5,060

5,060

5,060

Current Assets

 

 

100,348

120,483

243,790

287,324

339,801

Stocks

0

0

0

0

0

Debtors

37,019

43,243

46,785

52,399

58,687

Cash

39,870

41,827

158,692

192,015

233,055

Other

23,459

35,413

38,313

42,911

48,060

Current Liabilities

 

 

(95,031)

(49,551)

(49,948)

(43,125)

(35,916)

Creditors

(54,960)

(49,471)

(49,868)

(43,045)

(35,836)

Short term borrowings

(40,071)

(80)

(80)

(80)

(80)

Long Term Liabilities

 

 

(11,158)

(71,528)

(71,194)

(73,194)

(75,194)

Long term borrowings

(230)

(59,671)

(59,671)

(59,671)

(59,671)

Other long-term liabilities

(10,928)

(11,857)

(11,523)

(13,523)

(15,523)

Net Assets

 

 

192,374

223,396

354,321

403,774

462,951

CASH FLOW

Operating Cash Flow

 

 

33,954

46,069

66,181

74,690

83,643

Net Interest

(502)

(9,411)

(6,263)

(3,425)

(2,276)

Tax

(6,304)

(13,288)

(9,488)

(11,238)

(12,912)

Capex

(9,440)

(13,145)

(11,083)

(17,461)

(19,556)

Acquisitions/disposals

(25,766)

(27,762)

(19,481)

(7,823)

(8,289)

Financing

0

0

97,000

0

0

Dividends

(1,080)

(1,197)

0

(1,421)

(1,570)

Net Cash Flow

(10,090)

(18,734)

116,866

33,323

40,040

Opening net debt/(cash)

 

 

(11,094)

431

17,924

(98,942)

(132,264)

Forex gain on cash

(3)

1,293

0

0

0

Other

(1,432)

(52)

0

0

0

Closing net debt/(cash)

 

 

431

17,924

(98,942)

(132,264)

(172,305)

Source: Company accounts, Edison Investment Research

General disclaimer and copyright

This report has been commissioned by Keywords Studios and prepared and issued by Edison, in consideration of a fee payable by Keywords Studios. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

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General disclaimer and copyright

This report has been commissioned by Keywords Studios and prepared and issued by Edison, in consideration of a fee payable by Keywords Studios. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

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