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Keywords Studios - extra costs weigh on margins

Nicholas Hyett, Equity Analyst | 30 January 2020 | A A A
Keywords Studios - extra costs weigh on margins

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Keywords Studios plc Ordianry Shares 1p

Sell: 1,762.00 | Buy: 1,767.00 | Change -19.00 (-1.07%)
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Keywords' full year revenue will be in the region of €326m, up 30%, boosted by acquisitions. Organic revenue is expected to rise 15%.

Adjusted profit before tax is expected to rise just 8% to around €41m, as increased investment and the incorporation of recent acquisitions saw costs rise and weighed on margins.

The shares fell 4.8% in early trading.

See the latest Keywords Studios share price, charts and how to trade

Our View

Keywords Studios is a market leader in outsourced design, audio and translation services for game developers. Customers can "pick & mix" services which range from graphics to voice actors to testing.

The group works with lots of the world's biggest gaming groups, in offices all over the globe. That should see it benefit from the broad based growth in the gaming market - total gaming spend is expected to rise around 40% in the 4 years to 2022, reaching $196bn.

Building a global network has seen the group become a serial acquirer, buying smaller businesses as it looks to build the scale and expertise to serve more of its clients' needs. This makes sense to us, as Keywords looks to become the go-to provider of video game services, but acquisitions always bring risks. Inefficient integration can harm profitability and it makes it more difficult to spot lacklustre performance in the core business.

So far Keyword's strategy has been impressive. Earnings per share rose an average of 72.5% a year between 2013 and 2018, and analysts are forecasting further growth out to 2021.

However, the cost of integrating all those businesses, together with some early stage acquisitions, look set to hit margins this year and that's far from ideal. Given the services Keywords provides are inherently labour intensive, which is why developers choose to outsource them in the first place, margins are a key concern.

Net debt has risen this year and if weaker margins feed through to weaker cash flows (which we would expect) then the group's ability to self-fund new acquisitions will be hit. The good news is that the balance sheet isn't overstretched, but a reduced capacity for acquisitions makes continued organic growth crucial.

We see Keywords as an attractive way to play the general increase in gaming spend without taking on the franchise specific risks that go with individual publishers like EA, Activision Blizzard and Ubisoft. However we're not alone in seeing that opportunity. The shares currently trade on a P/E ratio of 25.8 times and offer a prospective yield of just 0.1%.

Investors should bear in mind that, as an AIM listed business, the group faces less stringent corporate governance requirements, which increases risk. Reduced liquidity could also mean the share price is more volatile than larger companies.

Register for updates on Keywords

Full Year Trading Update

Organic revenue growth slowed in the second half, with full year growth of 15% below first half growth of 17.3% - although remains significantly above the 10.1% posted last year.

The Functional Testing and Game Development divisions continue to perform well. However, the group as a whole has been navigating the slowdown in the development cycle for the current generation of games consoles, partially offset by upcoming releases for the new Xbox and PlayStation later in 2020.

Investment during the year includes expansion of facilities in Montreal, Katowice, Manila, Brighton, Mexico City, Tokyo, Sao Paolo and New Delhi and a new studio in Leamington Spa. However, this increased operational costs and combined with the integration of early stage businesses acquired in 2018, and a large underperforming fixed price contract, negatively impacted margins.

The group completed 8 acquisitions during the year at a total upfront cash cost of around €13m. Keywords also paid out €15m for deferred settlements on acquisition made in previous years, for a total acquisition cash cost of €28m.

Net debt at the year-end stood at €18m, from €0.4m a year earlier.

Find out more about Keywords Studios, including how to invest

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.