Is the UK gaming sector a buy?

So, I’m a keen gamer and have been interested in the sector and completing game research since the mid-eighties (at a guess). I currently hold Frontier Developments (FDEV) and Team17 Group (TM17) stocks. I purchased Team17 in the early stages of the Covid pandemic and Frontier within the last 6 months or so. Neither makes up a substantial portion of my portfolio and I need to look into whether they’re worth holding onto or perhaps increasing holdings in this sector, therefore I will also look into Keywords Studios (KWS) and Devolver Digitial (DEVO) for comparison.

A bit about each company…

Frontier Developments were founded in 1994 and are AIM-listed since 2013. They’re a developer and publisher of video games for personal computers and consoles. Frontier uses its own proprietary COBRA game development technology which should make the development of games both easier and more cost-effective for different platforms (PC, Xbox, Playstation etc). Frontier also publishes games that have been developed by partner studios under its Frontier Foundry label. Big titles from Frontier include Elite Dangerous & Jurassic World Evolution. David Braben has been at the helm since the company’s incorporation.

Team17 has been around for quite some time, founded at the end of 1990 and AIM listed in 2018. They are also a developer and publisher of video games for both PC and consoles. They partner and publish primarily Indie games from their publishing venture (never free-to-play games). The big games franchise from Team17 is Worms which has seen many different iterations since the mid-nineties and is still popular today. Other recent successes have been Overcooked (Team17 developed) and Hell Let Loose (developed by Black Matter). Debbie Bestwick is a co-founder of the company and since a 2010 management buyout leads the company as its CEO.

Keywords Studios is a slightly different animal from the two above. Founded in 1998 to provide localisation services for business software they’ve now pivoted towards delivering all sorts of services for the gaming industry, largely through acquisitions they now provide art studios, audio recordings, branding & marketing, analytics… yes all sorts, they’re also involved in game development or at least firms they’ve acquired are, they never it appears directly link Keywords Studios to games that are published (please correct me if I’m wrong). They even provide player support services which cover 24-hour support via tickets, emails, social, and in-game. They’re based in Ireland and listed on AIM.

Devolver Digital are based in the US, listed on AIM and are a relative newcomer to the sector having been founded in June 2009. They partner with independent developers and provide services to assist with the development, publishing and promotion of games across various platforms. They were originally set up to push digital content rather than physical (disc form) via platforms such as Steam on PC. They apparently have a film distribution business but this appears to have been removed from their website as of today’s date, perhaps they got bored of it? A recent big-name game that they’ve had involvement with is Fall Guys (which they’ve sold all publishing rights for during 2020).

Are they making any money?

Anyways, enough about the games and history. Are these sound investments to make? We are in the midst of a downturn and are seeing inflation figures at their highest level for a generation! We’ve just (hopefully) left a global pandemic behind us and everyone is allowed out again, who in their right mind would want to stay indoors and play computer games?

Well, interestingly the expectation is that the market is getting bigger every year with a CAGR of more than 9% out to 2026. Yes, the gaming sector had a boom during the lockdowns but this, in theory, has just grown the player count and with advancements in technology such as 5G and how quickly hardware is improving and becoming more mobile, there is no longer a need to stay indoors and play computer games. The whole online social experience is becoming more face-to-face, we will soon be using VR and AR on a regular basis (apparently) and on paper it’s actually quite an inflation-busting hobby, even if you pay for a game to play with friends or family, it’s generally a lot cheaper than a night out and can lead to many weeks or even months of enjoyment. With these in mind, we could see a lowering of share values in the short term but there aren’t many reasons to think this sector isn’t a good investment, so let’s try to pick a good company.

Now none of these companies pays out a hefty dividend, in fact, only KWS pays any dividend at all and the yield works out at about .09%, but they have paid this out in 4 out of the last 5 years so that’s a positive. So I need to look into which of these companies offers (a) the best value (b) the likeliest growth opportunities and (c) the lowest risk.

…the best value

We should look at a couple of factors here I think, the first is the trusty P/E ratio, then the book value per share (BVPS), see below.

A quick look into FDEV and their crazy high multiple, in their interim update things have got better and the P/E has come down drastically due to earnings per share increasing but their recent games releases have disappointed and the board have lowered full-year revenue expectations. FDEV’s main titles are doing worse than expected, Jurassic World 2 is behind its predecessor in terms of total sales, the new F1 management game didn’t sell as well as expected over Christmas and Elite Dangerous appears to be on a downward spiral. The shares still appear expensive compared to their peers and even if the bad news is behind us there could be some reputational damage done due to the poor updates completed on current titles. I’m holding my shares at present (nursing some heavy losses) and don’t intend to sell, I’m just not sure if now is the time to buy more.

I’ve owned shares in TM17 for quite some time and the P/E of 23 is more than reasonable, my shares are up more than 70% and at this level of value I wouldn’t have an issue with topping up my holding. Team17 have a very eclectic mix of games due to the indie development arm meaning they have a lot of small titles in the mix but they are not involved with free-to-play games. They have some new games coming out and one in particular in early development (Team17 publishing) called Marauders looks very promising. I actually think there is a possibility that TM17 could be a takeover target at these prices, as GBP is comparatively cheap a company outside the UK could be looking to swoop in. Debbie Bestwick (CEO) currently owns more than 20% of the share capital.

Based on the above it would appear that there is a lot of expectation that KWS will continue to grow and based on the last five years of consistent revenue growth this seems feasible but at more than an 80 P/E multiple I’m not sure I’d be willing to take that gamble? I know they offer a greater breadth of services but I’m not convinced this covers such high expectations with regard to the current share price. They are a very interesting proposition though and you’d have to assume that if the games industry is going to continue to grow then KWS is in a prime position.

Obviously, DEVO appears to be the best value and with a share price that is hitting all-time lows is now the time to snap up a bargain? In short, probably not. This low P/E is due to a significant drop in share price… matched by a drop in earnings. Although confidence may be waning at present it’s important to note that DEVO has zero debt and their current book value currently outweighs market cap, these two are quite important and indicate that perhaps the company has been oversold.

A long-term growth story

The gaming industry has been on a massive growth curve ever since the gaming industry became a thing and it shows no signs of slowing, but it’s now easier than ever to enter this market and there are new game developers arriving regularly so surely the growth we need for our companies is becoming more and more difficult to come by? That makes sense, but actually, all of these companies now offer their wealth of experience to third-party developers, so basically they can assist with development, publishing and marketing for smaller more agile indie developers, essentially the developer will make an approach, provide a pitch of how great their product is and if the above companies like the look of what they see they can dive in and strike a deal (and take a cut of the potential revenue). A lot like Dragons Den, but without the industrial feel and shiny shoes. This greatly reduces the risk for these companies, a lot of money can be burned during the initial research and game development stages.

It seems likely that the growth witnessed previously could continue, even through tough times. We have some huge players such as Amazon and Facebook making moves to take a larger slice of the industry so we can be confident that it is an investable market. Even during a downturn, the potential is there (as mentioned previously) that this market can continue, many weeks of family nights in could be yielded from just one game rather than one meal out. Plus with the industry increasingly making the world smaller via VR the potential for games within VR is massive. I’ve recently read that Iranians are using the Call of Duty game to speak to relatives in Iran as their usual channels for communication are harder to come by.

Should we invest?

Let’s do some quick pros and cons and then a summary…

Will I buy? (Summary)

There will be companies that struggle but overall this industry is going to get larger. We do have some headwinds and largely the price drops we’ve witnessed of late are covering this fact.

I’m currently keen on Team17 and will be topping up my holdings, this is based on a reasonable PE, decent leadership and consistent revenue increases year-on-year, beating market expectations. They have an impressive back catalogue which should continue to provide revenue going forward. This share price reduction is a good time to buy as far as I’m concerned.

As for FDEV, I’m already nursing some losses on this investment and although the profit warnings from earlier this year are a concern they have some big games and these big games have big potential. The recent share values are making me think that there is room for an upside here and I think the business is well-run and produces some great games. They also seem to be striking bigger deals EG the licensed F1 manager game and a Warhammer game expected during 2024, this is positive.

As for KWS and DEVO, they both intrigue me which is why they’re here. But for me, KWS is too pricey and I’m concerned I’d be overpaying for them. They are a very interesting business and I’m sure they have a bright future. DEVO are slightly too niche for me at present, certainly compared to TM17 and FDEV. They are very competitively priced though and are consistently making money.

OK, so I’m keen to diversify and think I will be splitting my investment, probably 60%-70% TM17 & 30%-40% FDEV, I’d love to buy into DEVO as well but at only 10% or so of the pot it’s hardly worth it, I will be keeping a close eye on them though.