Digital dynamos

The UK video game stocks taking the industry by storm
Thursday 09 Aug 2018 Author: James Crux

Are you seeking to plug your portfolio into an industry with dynamic long-term growth prospects? Then look no further than the global video games industry, which staggeringly, has become the world’s biggest entertainment market worth roughly $116bn a year, the combination of game devices, cloud computing platforms and the opportunity for fast digital delivery driving explosive growth in the number of consumers playing games.

Over the last five years, the massive downloads achieved by freemium mobile games have grabbed the headlines, but higher budget, quality-led creative games have become multibillion dollar franchises.

What has changed for PC and console game developers is the globalisation of their businesses, driven by cloud-based distribution. This has dramatically transformed the way they take their games to market, the economics and enhanced the opportunity to build long-term relationships with gamers.

As Liberum Capital outlines in a recent initiation note on AIM newcomer Codemasters (CDM:AIM) , ‘the economics for games developers have been transformed. Most developers retain sizeable, traditional (lower margin) boxed sales channels, but importantly, today they are able to go direct to the consumers with their “digital goods” or via platforms such as Xbox, PS4 or Steam, retaining around 70% of the post-tax retail selling price of the game’.

Growing global confidence in the gaming sector was in evidence at the recent E3 computer game conference in Los Angeles, where Microsoft announced the acquisition of four studios and plans to open a new additional studio in Santa Monica.

Video games are a bright spot in an otherwise gloomy UK consumer space, where quoted players include self-published game franchises creator Frontier Developments (FDEV:AIM) and junior market newcomers Sumo (SUMO:AIM), Team17 (TM17:AIM), Codemasters and technical services provider Keywords Studios (KWS:AIM).

Another way to play the gaming boom is GAME Digital (GMD), transforming into the leading eSports venue organiser via a joint venture with Sports Direct (SPD). The growth of eSports, the activity of watching others game competitively, has been spectacular, generating $493m in revenue in 2016 with an audience of 320m people.


Spending on video games hardware and software has exploded over the last five years, ahead of all other major entertainment and media categories. David Wilton, chief financial officer of Sumo, says this is ‘one of the most positive sectors I’ve come across. It is still very immature and fragmented.

‘The average age of the gamers is going up every year and we’ve got more and more people playing games in new parts of the world. In the past, the sector was lumpy and the quality of the games was variable.’ Yet today, ‘the graphics are stunning, the quality of the games is incredible and there is more demand than there is capacity to supply the games.’

Structural shifts are afoot in video gaming, a highly addictive leisure activity with resilient qualities, notably the marked shift from purchases of packaged software to digital downloads, which improves the profitability of video game companies and makes it easier for them to expand internationally.

Another benefit from the digital shift is the move towards a ‘Games as a Service’ concept where it is standard for games to be designed for long term play, supplemented by downloadable content (DLC) that users pay extra fees for on top of the original purchase of the game.


Liberum Capital number cruncher Andrew Bryant has immersed himself in this exciting sector and informs Shares that ‘investors have in the past focused on high development and launch costs, the emergence of free mobile games, and the perceived binary outcome of an individual game’s success.

‘However, games developers today have a deep understanding of the Games industry eco-system, place significant emphasis on extensive dialogue with an engaged player community, refines and pre-markets with reviewers and vloggers.’

Bryant continues: ‘Ten years ago the IT challenge of delivering a great gaming experience onto the PCs and consoles of players around the world, meant that publishers were forced to take stock risk to burn vast amounts of data onto disks and sell them through complex, global physical retail chains.’

Bryant highlights how improvements in broadband and mobile networks have supported a shift from physical retail to online digital distribution.

‘The combination has contributed to an explosion in the number of global consumers playing games and the economics for the game developers. For companies like Frontier that previously sat towards the back of the supply chain developing the games (ideas, creation, coding), they received a disproportionately low percentage of the selling price in return for their high IP contribution.

‘Today their “digital goods” are produced and can be distributed over the network at marginal costs approaching zero. Frontier and other game developers are therefore able to go direct to the consumers and retain close to 100% of the retail selling price of the game.

‘We believe there is still scope for the whole gaming sector to be further re-rated as investor’s value their global B2C cloud software businesses.’

In a March note entitled ‘TECHNOLOGY: MORE THAN JUST FUN AND GAMES’, Peel Hunt trio Ashu Sony, Damindu Jayaweera and James Lockyer highlight a concentration of global publishers in the US and Asia, yet they stress ‘the UK remains an important gaming hub with a worldwide presence.’

The Peel Hunt trio says ‘the UK has a rich history in the global gaming space, pioneering global hits including GTA, Lemmings, LittleBigPlanet, Elite, TimeSplitters, Wipeout, etc. Such wide success can be attributed to talent.

‘The Global Talent Competitiveness Index shows that the UK is one of the top three countries in the world at attracting and retaining talent in the digital industry. UK universities also offer well -respected gaming degrees and the UK has multiple talent hubs for gaming: Manchester, Newcastle, Birmingham and London are the largest. With the government also providing support in the form of video game tax relief (VGTR), the UK has a thriving video game market.’

And a resilient one at that. Trade body UK Interactive Entertainment recently highlighted that the UK experienced 12% growth in gaming expenditure in 2017, despite pressure on UK disposable incomes, crediting ‘an ever expanding audience’.

The growth was fuelled by an increasingly larger audience demanding digital games and the success of new titles such as FIFA 18, Assassin’s Creed Origins and Star Wars Battlefront II.


Some of the UK’s smartest fund managers have put money to work in the industry, among them Michael Lindsell, manager of the Lindsell Train Japanese Equity Fund (0438418), which recently opened a position in Square Enix, one of Japan’s leading video game publishers.

Lindsell argues ‘the investment case behind Square Enix is underpinned by its unique and rare collection of IP with Final Fantasy standing out in particular as one of the top ten selling video game franchises of all time.

‘The video game industry’s digital shift away from a ‘units sold’ model to a ‘Games as a Service’ model based on users, engagement and digital monetisation presents Square Enix with a material opportunity to generate top and bottom line growth.’

And Ben Rogoff, manager of the Polar Capital Technology Trust (PCT), explained in his recent full results commentary, ‘Computer gaming companies enjoyed another strong year with most of our holdings’ - positions include Activision and Electronic Arts and Take-Two Interactive ‘significantly outperforming the technology market.

‘With two-thirds of American households regularly playing them, video games have truly evolved into a mass market medium. Adoption has been enabled by the proliferation of increasingly capable electronic devices and Internet connectivity, which has enabled the creation of large player networks and digital distribution.’

Interestingly, Rogoff added: ‘While we remain constructive on the group, we are continuing to monitor the progress of Fortnite, a free to play console (and now mobile and PC) game which has attracted more than 45m players with a new game genre (“Battle Royal”).

‘Unlikely to pose much risk to existing AAA franchises, the back-end only monetisation of Fortnite is new to console gaming and could potentially prove disruptive over time.’ (JC)


Frontier Developments (FDEV:AIM) £11.05

Founded in 1994 by CEO David Braben, co-author of the seminal Elite game, Frontier Developments’ (FDEV:AIM) shares have soared since its July 2013 AIM debut at a 127p issue price.

Chinese internet-to-interactive entertainment titan Tencent put its stamp of approval on Frontier last summer, investing £17.7m in return for a 9% stake, to help Frontier attack the vast Chinese market and scale-up by increasing the frequency of major releases.

Frontier Developments enjoyed material forecast upgrades for the year ending 31 May 2019 following a positive trading update (3 Jul), in which it flagged early success with its third game franchise, Jurassic World Evolution, which has quickly passed 1m units sold.

Significantly, the upgrade was based on forecasts for the Jurassic World title, together with the expected performance of Frontier’s first two franchises, Elite Dangerous and Planet Coaster. Both are performing well and in addition to producing its own games, Frontier will also consider third party publishing to accelerate its growth plan, namely controlling the promotion and distribution of other developers’ games.

FinnCap analyst Lorne Daniel’s upgraded full year to May 2019 forecasts point to a leap in sales from £34m to £75.3m, sending adjusted profit before tax roaring higher from £2.6m to £16.5m, with potential for further upgrades if success continues. (JC)

Codemasters (CDM:AIM) 216p

Recent share price weakness at this video games publisher presents a buying opportunity. One of the most recognised British games developers, it specialises in premium quality car racing games and holds exclusive licensing rights for the Formula 1 game franchise and also has three own-IP racing franchises: DiRT, GRID and ONRUSH.

Founded by the Darling family in 1986, the company boasts a loyal fan club of gamers, a balanced racing games portfolio and strong ties to leading car manufacturers and automotive brands.

The company has been successfully turned around by the current management team, led by CEO Frank Sagnier, with sales and adjusted earnings before interest, taxation, depreciation and amortisation (EBITDA) having increased year-on-year since 2015.

The £15m of fresh growth funds raised at IPO will help Codemasters extend the reach of its existing franchises onto more platforms such as mobile and virtual reality and beef up marketing to reach a wider audience of gamers. Liberum has initiated coverage with a ‘buy’ rating and 310p price target, implying the best part of 45% upside.

The broker’s estimates for the year to next March suggest a pre-tax profit surge to £16m (2018: £11.6m) for earnings of 11p, ahead of £18m and £20.5m in 2020 and 2021 respectively. (JC)

Sumo (SUMO:AIM) 171p

This small cap games developer has made a solid start to quoted company life and is attractively positioned as a premium services partner for global games publishers.

Maiden full year results (24 Apr) came in slightly ahead of estimates with revenues up 39% to £28.6m and adjusted PBT 42% higher at £7.5m. Boasting £12.4m net cash in the coffers and a strong cash flow profile, the business has adequate resources for strategic M&A in a fragmented industry.

Debuting on AIM in December, having raised £38.45m of fresh funding at 100p, the company is growing organically as one of the world’s leading co-developers of AAA-rated gaming titles. Its work-for-hire model means it is not exposed to risks associated with the hit driven nature of a games publisher and has high visibility compared to peers.

As CFO David Wilton explains: ‘We either do a turnkey solution or we do co-development and we get paid every month by delivering against milestones. We get profits and cash over the life of the project and an upside (from royalties) at the end if the game is successful.’

Core business Sumo Digital is a leading developer of AAA-rated video games operating out of studios in England, India and Canada. For 2018, Zeus Capital forecasts adjusted pre-tax profit of £9.1m (2017: £7.5m), rising to £12m in 2019. (JC)

Team 17 (TM17:AIM) 255p

This recently floated games developer has been around for the best part of three decades, but its development was accelerated by a management buyout in 2011.

Steered by chief executive Debbie Bestwick and numbers man Paul Bray, the company is perhaps best known for its Worms franchise which was a big success in the 1990s.

However, it is now a much more diversified business thanks to its Team17 Games Label platform which allows indie developers to bring games to the market through a revenue sharing model.

Accordingly, Worms has gone from accounting for 80% of group revenue in 2014 to just 18% by 2017. The shares aren’t cheap at around 32 times Berenberg’s forecast earnings per share but are justified by the growth profile. Particularly given the scope for positive earnings surprises.

On 18 July the company confirmed it was on track to hit full year expectations and it has just launched a sequel to its well-received Overcooked title.

Bestwick says: ‘The announcement of Overcooked 2 and early access launch of My Time At Portia provides further evidence of our commitment to building brands and collaborating with some of the most creative indie partners around the globe.’ (TS)

Keywords aims to unlock gaming’s full potential

Working behind the scenes for some of the big game developers, Keywords Studio (KWS:AIM) has 23 of the top 25 game producers as clients and using a buy and build model is picking up new companies and offerings at a tremendous pace.Keywords is not reliant on the success of a single game or even a handful of titles. It provides the ‘picks and shovels’ to get these products to market and is paid regardless of how popular they are.

The model clearly appeals to investors, at £17.14 the shares are up nearly 13-fold on the issue price from its July 2013 IPO and trade on a price-to-earnings ratio of 40.3 times 2018 forecast earnings per share.

Andrew Day, CEO of Keywords says he’s not really after more clients as his list is already stellar. Moreover, given the amount of services he can offer his clients, he wants them to use his company for multiple tasks.

‘One of the problems we’ve had as we’ve increased our level of capabilities is to show our clients the level of our new offering,’ says Day.

Day says the big trend at the moment is a move into games that are continually supplying new content into existing games. This is to keep players ‘engaged’ according to Day and the new content can come weekly or even daily.

Another ‘big thing’ Day has noticed is the increasing sophistication of mobile games. The old MMO (massive multiplayer online) model mobile games is merging with a pay to play model and ‘people are willing to play more and more sophisticated’ games on their mobiles.


The company recently moved into gaming analytics with the acquisition of Yokozuna Data for $1.6m. This move was hot on the heels of the purchase of Snowed In, a software engineering firm.

Day explains that predictive analytics is about being able to read when players are about to leave and trying to increase the level of spend within a game.

In terms of the price Keywords has paid for its astounding number of acquisitions, Day surprises with his response.

‘We are the known buy and consolidator in this sector so we can set the price. Most of the conversations in this space are less about valuations and more about making sure they are getting the same sort of deal out of the Keywords deal that others got,’ says Day.

In its earlier incarnations, Keywords was a company offering translation services to games producers to enable them to market their games to a wider audience.

From a single service line business, Keywords now offers seven service lines and has an addressable market of around $6bn.

Keywords is becoming more vital in the game production supply chain as it diversifies its offering with each new acquisition. (DS)

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