Description

Keywords Studios Plc (KWS LN EQUITY)

Executive Summary

Keywords Studios Plc (“KWS” LN EQUITY) is a high-quality compounder that has a long growth runway, a favorable industry structure, and trades for a reasonable valuation despite strong execution and a roadmap for continued shareholder success. Insiders own over 10% of shares outstanding and have led the company to a 50%+ total shareholder return CAGR since the company went public in 2013. I believe the company has an unusually long runway of 20%+/year EPS growth, which should lead to continued strong returns for shareholders at an entrance price of <30x fwd EPS.

Market Background

Video game publishers have always been notoriously difficult work environments. Companies scale up hiring as they ramp production on a new game. These new hires are subject to a very demanding and high-pressure work environment as there is a tight game deadline. Once the game is released, a large percentage of those hired workers are terminated because they are no longer needed once the game is complete. This boom and bust hiring cycle is inefficient and leads to poor morale. Increasing game complexity in recent years has exacerbated this issue. Game creators now need a small army of highly specialized developers, artists, and project managers to create and distribute a high-profile video game worldwide. It is challenging and inefficient for studios to manage this entirely in-house due to the difficulty of identifying, hiring, and utilizing this small army of talent efficiently. 

Background on Keywords Studios/ The Outsourcing Industry

Enter Keywords Studios (“KWS”). This European-based company (headquartered in Ireland, trades on the London stock exchange) is the largest outsourcer of video game production in the world. They have rolled up the industry by buying small studios all over the world that offer various aspects of video game development including art creation, engineering, customer support, audio licensing and development, localization translation, and functional testing. The company now has the in-house capabilities to develop an entire game for their clients if needed (though this has not happened yet).

The company has more than 50 studios located in 40 cities worldwide and 21 countries providing full, integrated services by combining a presence that is local to their clients in key gaming cluster with lower cost production sites across four continents. They have 6,000+ people on the payroll at peak times, provide services across 50+ languages, serve 23 out of the top 25 gaming companies measured by revenue. 

The video game industry is growing at a roughly 6%-9% global rate (depending on data source—KWS). The outsourcing industry is growing a bit faster than that at about 10-11% growth. KWS has been outpacing (on an organic basis) the growth of the outsourcing industry: growing organically in the mid-teens.

Why is KWS Attractively Positioned? 

• KWS benefits from the strong industry tailwind of a gaming industry growing high-single digits per year for the foreseeable future. I strongly believe the tailwinds for gaming will continue as the technology keeps improving and it is a relatively cheap form of entertainment.
• While the industry is growing high-single digits, the dollars spent on outsourcing is growing at an even faster rate as the industry continues to achieve better service and affordability with outsourced providers. 
• We are still very early in the shift to outsourcing in video games. Only ~40% of videogame services spend is spent on outsourcers today. Over time, the gaming industry is likely to develop similar to the film industry, which used to have most expenses in-house, but now outsources ~90% of production costs.
• KWS is the only player with scale in the outsourcing industry. They work with 23 of the top 25 gaming companies (measured by revenue) and can offer any service with multiple price points and geographies. They have cultivated these relationships over many years which creates both a technical expertise (working on the same games and expectations from year to year) and a cultural trust (leaking game info ahead of a launch is a serious offense that publishers have to guard against).
• KWS’ model is working. In the last five years (2014-2018), the company expanded revenue from 37.3M EUR to 250.8M EUR (572% increase), EBITDA from 5.9M to 40.2M (581%), and earnings per share from 0.07 to 0.29 (314%). As a result, the company’s stock price has increased over 850% over that timeframe. Despite this tremendous historical and likely future growth, KWS is trading for <30x forward earnings. I think this is very cheap given the long runway for 20%+ EPS growth. 

How the Business Model Works and What The Future Holds for KWS

The market for outsourcing services is highly fragmented. KWS is the only player with scale. The majority of the competition offers one or two service lines with limited geographical reach. Many studios have high customer concentration risk, have a small number of key employees, and do not have the level of professionalism and financial stability desired by a large gaming company looking to outsource services. 

KWS has consistently purchased individual studios for 5-10x EBITDA and then integrated them into their service offering. These studios generally specialize in one individual vertical and the typical purchase price is between 5-20M EUR. Many of these studios do not even have a sales team. By joining KWS, these small studios diversify their customer concentration risk, are introduced to new potential clients, and often consolidate back office and facilities expenses. 

Thus far, KWS has grown revenue organically and inorganically at attractive rates, but has not realized any margin expansion. This is mostly due to the fact that a) the company has been in constant acquisition mode so there are always assets that are not fully integrated and b) the company is trying establish leadership positions in each vertical they operate in before pushing the pricing lever. On an individual acquisition basis, the company has provided numerous examples of cost and revenue synergies leading to very attractive post-synergy acquisition multiples. There are meaningful switching costs involved when a developer goes from one outsourcing provider to another. Over time, KWS will likely be able to flex ~5% pricing power, which is less than the risk of switching to a new provider that has not worked on your games for years. The company has suggested that they should eventually be able to get some operating leverage over time, though this is not expected in the immediate-term given the appetite for continued acquisitions.

Also, while the company in its infancy had to rely primarily on equity financing for acquisitions, the company now is in a very solid financial position and should be able to utilize low cost debt. The company is comfortable going up to 2x net levered versus 0x today. Increasing operating margins and lower dilution will further juice the total shareholder return algorithm. 

Risks

• Macro slowdown/ reduction in discretionary spend on videogames

   

  -Mitigant: video games are a very cheap form of entertainment on a cost/hour basis. Furthermore, a recession is likely to accelerate the shift from in-house game development spend to outsourcers.

• Deal integration

  -Always a risk with roll-ups. Thus far, KWS has done pretty well and they certainly take the finer aspects of the gaming industry (i.e. culture) seriously when considering the feasibility of deals (not just a financial exercise/hedge fund math). That being said, if they deviate from their “sweet spot” in terms of deal size, it would be something to watch closely. 

• Barriers to entry are low/ KWS will be copied

  -Mitigant: The barriers to starting an art creation studio or any one of KWS’ other service lines is fairly low. However, the barrier to creating a studio at scale is quite large. Relationships with the top gaming companies take years to cultivate. Being trusted with game information before a title is released or in many cases even announced requires a strong relationship between the publisher and the outsourcer.

  -Mitigant 2: KWS has years of experience in integrating different game studios. Gaming companies often have very unique cultures and KWS has been a preferred acquirer. 

  -Mitigant 3: KWS is starting to develop meaningful scale in many of their service lines. This allows them to be a “one-stop shop” for many outsourcing needs, greatly simplifying the vendor management task of the video game publisher. 

  -Ultimately, there likely will be more consolidation, but no one is close to KWS’ scale today and there is plenty of room for multiple winners.

Conclusion

KWS is riding a very powerful trend (outsourcing) within a rapidly growing industry. As the leader in video game outsourcing, KWS is poised to benefit from more cross-selling of services and deeper relationships with their clients over time. KWS is effectively a pick and shovel seller to the videogame industry. They benefit from the industry’s growth, but they have minimal direct exposure to the successes or failures of individual game titles. I believe KWS’ strategy will continue to be a winning formula for shareholders and that we are in the early innings of both outsourcing and KWS’ market outperformance. While I will abstain from an exact point-in-time valuation target given the uncertainty around the timing and size of acquisitions, I think the long-term CAGR will approximate the EPS CAGR going forward, which is likely to be 25%+ for the foreseeable future. It is not hard to justify multiples of upside from the current price given some margin improvement, continued organic growth, continued deal execution, and a constant or slight multiple fwd earnings multiple compression. 

Legal Disclaimer

• The author may change his views about or his investment positions in KWS at any time, for any reason or no reason. He may buy, sell, or otherwise change the form or substance of its KWS investment. He disclaims any obligation to notify the market of any such changes. 

   

• The information and opinions expressed in this report are based on publicly available information about KWS. The author recognizes that there may be non-public information in the possession of KWS or others that could lead KWS or others to disagree with the author's analyses, conclusions, and opinions. 

   

• The report includes forward-looking statements, estimates, projections, and opinions on KWS, as well as more general conclusions about KWS’s anticipated operating performance. Such statements, estimates, projections, opinions, and conclusions may prove to be substantially inaccurate and are inherently subject to significant risks and uncertainties beyond the author's control. 

   

• Although the author believes the report is substantially accurate in all material respects, he makes no representation or warranty, express or implied, as to the accuracy or completeness of this report or any other written or oral communication it makes with respect to KWS, and the author expressly disclaims any liability relating to the report or such communications (or any inaccuracies or omissions therein). Thus, shareholders and others should conduct their own independent investigation and analysis of the report and of KWS and other companies mentioned. 

• Except where otherwise indicated, the report speaks as of the date hereof, and the author undertakes no obligation to correct, update, or revise the report or to otherwise provide any additional materials. The author also undertakes no commitment to take or refrain from taking any action with respect to KWS or any other company. 

   

Catalyst

More deal announcements

Strong eps growth

Good Capital Allocation