Interactive Investor

Stockwatch: a £1bn AIM share to consider for your ISA?

This company is a leader in its field, and financial returns could kick in this year. Analyst Edmond Jackson assesses the scope for a re-rating if acquisitions meet expectations.

15th March 2024 11:32

Edmond Jackson from interactive investor

It is interesting to consider AIM-quoted Keywords Studios (LSE:KWS), an Ireland-based provider of technology solutions to the global video games and creative industries, after broadly strong 2023 results, and a share price that’s de-rated to where it traded four years ago.

At around 1,420p currently, it is also more than 50% down on the 3,250p reached in September 2021when lockdowns boosted video gaming.

Last year, there was an industry slowdown, but management is now optimistic about 2024 and has positioned the group boldly with five sizeable acquisitions. Things could therefore come together dynamically and – if you accept their adjustments to earnings – the forward price/earnings (PE) ratio may only be around 13x versus 60x during the pandemic.

Meanwhile, the yield is barely 0.2%, hence it is no prop should anything go wrong with acquisitions, or the industry disappoints again.

Yet Keywords is a well-established and market leader in its field, and a scenario exists where financial returns do kick in from 2024. It is therefore potentially a share to consider for an ISA or SIPP, given scope for capital upside to shield from tax.

Keywords Studios - financial summary
Year end 31 Dec

Turnover (€m)151251326374512691780
Operating profit (€m)16.422.721.541.150.471.846.8
Net profit (€m)7.314.910.021.634.247.420.0
Operating margin (%)
Reported earnings/share (euro cents)11.922.214.928.843.158.924.9
Normalised earnings/share (cents)14.927.618.624.850.266.244.3
Operational cashflow/share (cents)22.348.048.7102114154138
Capital expenditure/share (cents)6.216.520.118.924.834.242.2
Free cashflow/share (cents)16.131.528.683.389.312095.8
Dividend/share (cents)
Covered by earnings (x)7.212.425.70.016.822.08.3
Return on total capital (%)9.611.
Cash (€m)30.439.941.810310681.959.9
Net debt (€m)-11.10.439.8-74.0-67.9-39.3114
Net assets (€m)161192223371472557599
Net assets per share (cents)262303351501619714756

Source: company accounts.

Serving 24 of the top 25 games companies

The group has over 70 facilities in 26 counties, and management proclaims that with a market share of 6% they are “incredibly well-placed to grow share in a fragmented market”.

This is a 25 year-old business, initially in software then evolving as the proverbial “one-stop shop” for video game development. From a base in Ireland, offices were opened in Tokyo, Montreal and Seattle, progressively some 15 years ago.

A mid-2013 flotation at 123p a share raised £28 million and served as a platform for acquisitive development. Nowadays, the services include art, engineering, functionality testing, audio recording, translation, player support and public relations. They effectively make the shares a play on the state of activity in video gaming. Keywords is therefore less risky than a content provider where you are trying to guess if a blockbuster game can be devised and how long it might last.

In old-fashioned terms, it is a similar investment proposition as “picks and shovels” mining services than speculating on mining operations. This implies judging activity in video games creation, where Keywords’ CEO says: “the industry backdrop remains tough in the near term”.

But that indeed makes it the right time to be acquiring – where 2024 is said to offer an “extensive” pipeline – and accumulating shares if improvement does lie ahead.

Management expects “a gradual improvement in market conditions and we remain confident in the medium-term backdrop. Player numbers continue to rise...the mobile market appears to be returning to growth...hardware challenges have eased...industry forecasts point to continuing long-term growth in the vast video-gaming market.”

It’s unclear quite whether those analysts are independent, or part of the industry – hence telling them what they want to hear. To me, a key question seems whether enough people are attracted to video gaming, if another form of media supplants it, or post-pandemic behaviour has shifted in favour of genuine life experiences?

I recall video games shares such as Eidos being a fascination 20 and more years ago, hence there seems longevity. Again, it is unclear whether advancing AI boosts such appeal and becomes integral to Keystones’ service offerings, or replaces some of them. Uncertainties are involved but are often the case with dynamic industries.

How fair are major adjustments to the income statement?     

This is a key concern given scope to take different views on valuation.

While 2023 gross profit has advanced 12% to €299 million (£255 million) it has whittled down to €47 million reported operating profit – after nearly €22 million for a share-based payments expense, €27 million costs of acquisition and integration, €26 million amortisation of intangibles and a hefty €177 million “other admin expenses.”

Yes, adding back such costs enables a see-through to underlying business performance; but strictly I would only recognise amortisation, the rest are genuine costs borne by shareholders.

In which case, a more fairly adjusted operating profit would be €73 million versus €89 million in 2022, an 18% drop.

Long-term debt of €127 million has been added to the balance sheet to fund acquisitions, alongside €47 million leases and nearly €60 million cash. Net debt of €114 million and a reduction in cash held has therefore trebled the net interest charge to €12 million.

You could therefore say true adjusted net profit was €46 million (£39.3 million) equating to earnings per share of 50p – hence a trailing PE multiple of nearly 29x at the current 1,420p share price.

It also alters the operating margin prowess: down from 15.6% as professed, to 9.3% if adjusting simply for amortisation, albeit still plenty respectable. Regarding margins, I do think it fair to look past all exceptional costs to understand what the business is achieving.

But it is some sense of entitlement how this management team is being awarded 1.8% of the company annually, additional to regular remuneration. Is the board genuinely aligning shareholder interests with that of managers?

Scope for underlying re-rating if acquisitions deliver

2023 saw mixed performance across the group’s three divisions: strong demand for “create” which now represents over half of profits, offset by a said temporary moderation of demand in “globalise” also to a lesser extent “engage”.

Aside from such abstractions, group revenue grew 6% despite a 3% setback from US entertainment industry strikes and adverse foreign exchange. Otherwise, organic growth of around 9% would have been slightly behind guidance, yet still good.

A carrot is extended, though, with 2023 acquisitions “expected to grow strongly in the coming years as we continue to evolve towards higher-value services.”

Five studios were acquired for €195 million cash and a possible €30 million possible deferred consideration. They achieved €90 million revenue in 2023 (including pre-acquisition revenue) at margins above the current group, in context of €780 million group revenue – hence potential for a double-digit percent profit increase in 2024. That is unless “higher interest rates for longer” crimps that growth with extra cost on debt.

Three hedge funds still think Keywords is a short

Above the 0.5% of issued share capital threshold required for disclosure, a total of 3.1% is sold short, with two such traders borrowing to sell slightly more in January and March.

My hunch is that they regard Keystone’s business model as high-risk given its acquisitive pace, and they take a conservative view of genuine earning power, and judge video gaming to be in fundamental decline.

The seven-year financial table does however show consistent progress, as if management knows how to acquire businesses. Cash cannot be fudged and, while I question “adjusted” earnings, free cash flow per share has trended substantially in excess of earnings anyway.

Sceptics could still say: prove that by raising dividends instead of the ridiculous situation how (according to consensus forecasts) earnings cover for a 3 euro cents dividend will be 45 times.

Scope for different views

I conclude with a “hold” stance given a few red flags able to embarrass a “buy” rating. But I think there is a scenario where this industry improves and with Keywords more strongly placed – such that earnings and cash flow materially advance and its stock rises.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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