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3 Small Caps to Profit from the Games Industry

Computer, video games, Xbox, Playstation, Gaming, Keyword Studios, Sumo Group, Frontier Development

As the likes of Netflix and Spotify – not to mention Amazon and Apple – continue to change how consumers watch television, films and listen to music, there is another contender for the top growth industry crown.

Today, the video games industry is larger than all three industries individually. In 2018, the industry generated almost $135 billion in revenues, according to data from analytics provider Newzoo. That’s a year-on-year rise of 10.9%.

A switch towards free-to-play games like Fortnite, which make their money through in-game purchases, is dampening demand for consoles. But for consumers, this is much more convenient. Rather than having to traipse down to your local HMV, you can just sit at home, download a game and start playing.

This helps games publishers, who no longer have inventory and distribution costs. They can also turn them from one-off purchases to subscription models, through those in-game purchases and add-ons.

For developers, too, it helps as more and more games are coming to market, meaning more work. As a result, the sector continues to be fertile ground for fast growth.

London’s junior market, AIM, houses a selection of video games developers. Below, we pick three exciting growth stories and find out the investment rationale behind them.

Keyword Studios (KWS)

For a long time, Keyword Studios has been AIM’s most successful video games company. At around £700 million market cap, it is the largest of the cohort.

Keyword provides a plethora of services – from visuals to audio to localisation and translation – to the likes of Sega, Nintendo and Ubisoft. It’s based in Dublin but has a presence in over 20 countries.

James Henderson added it to his Henderson Opportunities Trust (HOT) at IPO in July 2013. But “for a long time, not much happened,” he recalls. In the first two years it gently ticked up by a third; by the following July, it had doubled.

From mid-2016, the share price started to proceed upwards, boosted by better-than-expected results and successful acquisitions. Jon Hudson, manager of the Premier UK Growth fund, says it has always been “an upgrade stock”.

Between July 2017 and August 2018, the share price went up 150% to peak above £20. This success meant the company was getting bigger and forecasts more ambitious.

“The bigger they got, the bigger the acquisitions they needed to hit the expectations the market was pinning on it. The bigger they got, the riskier the acquisitions were,” explains Hudson. He sold out completely last summer: “It just got too expensive.”

The valuation metrics the market had attached to the stock were “confusing”, he adds. “The market was valuing it on an adjusted price/earnings ratio, which strips out acquisition costs, but pricing in future acquisitions. That’s quite confusing – you have to do one or the other.”

Interims disappointed, too, with the company blaming Fortnite. Henderson says he reduced his holding in the summer: “I thought the valuation was getting quite stretched.” But he didn’t sell out fully because “it is a big growth space and there’s a real enthusiasm there from management”.

He explains that the acquisitions have worked well so far: “Management spent a lot of time thinking about whether they wanted to join the company. They all bought into Andrew [Hall, CEO]’s vision. If that’s happening, these acquisition machines can work well.”

Of course, with the late-2018 market sell-off, the stock has de-rated significantly. Today’s share price of £11 sits almost 50% below the peak, which could tempt buyers like Henderson back in.

“I’m looking for a bit of weakness to buy them back, to be honest. It’s now very reasonably rated and, while it’s difficult to know the exact underlying growth with these acquisition machines, the like-for-likes look reasonably good.”

Sumo Group (SUMO)

Sumo listed on AIM more recently, in December 2017. The Sheffield-based firm has developed flagship franchise brand games including Sony’s Little Big Planet, Sega’s Sonic The Hedgehog and Microsoft’s racing game Forza.

Sumo offers two services for the large clients with which it partners: turnkey, where a company will give it the idea and Sumo develops the whole things from start to finish; and co-development, where Sumo will partner with a client and develop the game together.

Chief executive Carl Cavers co-founded the company in 2003 and still owns almost 5% of the shares, something Liontrust’s Matt Tonge, who owns Sumo in his UK Smaller Companies and UK Micro Cap funds, likes to see in his companies.

The industry is growing fast, and so is Sumo. Its September half-year results showed adjusted revenue up 48% to almost £20 million, with adjusted gross profit up 56% to £8.2 million.

Gross margins of 35% are strong, while return on capital at 19% is very high. “This tells us that their assets are working for them and hopefully as shareholders we can benefit from the compounding this is going to deliver,” says Tonge.

Hudson adds that Sumo is much lower risk than a traditional games publisher. This is because it earns the vast majority of revenues before a game is released, meaning it doesn’t matter as much whether the game is a hit or not.

That said, their games are strong, with its most recent project, Hitman 2, getting very high review scores.

Having seen strong gains since IPO – up 82% by mid-September 2018 – Sumo was caught up in the market sell off in the fourth quarter, retracing to 106p by Christmas. Currently at 124p, Hudson says the firm is trading on around 30 times price/earnings with growth of 30% per annum, putting it on a price/earnings-to-growth ratio of 1 times.

“We just think the culture of this company is very good, it’s a high returns business, it’s got cash on the balance sheet, it’s growing really fast,” he adds.

Frontier Developments (FDEV)

Frontier Developments begun as a business developing games for third-party publishers. It had huge success working for Microsoft on Disneyland Adventures; Konami on Wallace & Gromit; and Atari on Rollercoaster Tycoon.

Today, though, it develops and publishes its own games. It has released three in the past five years: Elite Dangerous in 2014; Planet Coaster in 2016; and Jurassic World Evolution last year.

This is higher margin than developing games for third-party developers, says Matthew Hall, manager of the Allianz UK Mid Cap fund.

Hall speaks highly of chief executive and founder David Brabin. Brabin, who owns almost a third of the business, has over three decades of experience in the sector.

“He’s got a real passion for the video games industry and really understands what makes a good and successful video game,” Hall explains. “He wants to make video games that not only are successful and profitable, but that people really enjoy playing.”

Frontier will announce its fourth game in the coming six months and has said it will be developed off its own intellectual property, rather than a licensed game like Jurassic World.

This is a risk and won’t sell as many copies, but Brabin knows what the public wants. The most credible rumour suggests a zoo-type theme park simulation game. “Frontier might have spotted a niche in this area.”

In the immediate term, that is the most obvious catalyst for the share price, which has halved since hitting an all-time high 1,825p in June. That said, “until the market knows what the next game is, I think it struggles to fully price in exactly how successful that game can be”.

“No one knew what and how successful their last franchise would be and when they announced it was Jurassic World Evolution the market got very excited about it [and the share price nearly doubled within three weeks]. You may see something similar with franchise four.”

First-half results earlier this month were strong, with revenue jumping a huge 240% year-on-year to almost £65 million. Shares rose 13% on the update and led broker finnCap to up its full-year 2019 sales estimate to £83 million, 144% higher than 2018.

Earnings are likely to dip in 2020, before surging higher again in 2021, but Hall hopes Frontier can hold revenues flat next year, “which would be a positive surprise to the market”.

A forward earnings multiple of 22 times “offers excellent value for a high-quality growth business with such a strong intellectual property base”, according to director of research Lorne Daniels. Meanwhile a free cashflow yield of 3-5% “suggests the stock is significantly undervalued”.