Cube Midcap Report (18 Sep 2019) – Gaming champ #KWS #KGF #BLND

Cube Midcap Report (18 Sep 2019) – Gaming champ #KWS #KGF #BLND

Good morning,

It’s Roland here with today’s Midcap Report. The companies I’m planning to cover today are:

  • Keyword Studios (KWS)half-year results and another acquisition from the video game services group
  • Kingfisher (KGF) half-year results from the embattled Anglo-French DIY retailer
  • British Land (BLND) – an a brief update on retail letting activity from this FTSE 100 landlord

Keyword Studios (KWS)

  • Share price: 1,323p (-6%)
  • Market cap: £890m

Half-year results and acquisition

The Keyword Studios share price is down slightly today, but the latest figures from this technical services provider to the gaming industry look okay to me.

The group is acting as a consolidator in this sector and owns a wide range of companies providing services to gaming production companies. Examples include art services, audio services, localisation, quality testing and software development such as porting (adapting games to operate on different platforms).

Summary: Revenue rose by 39.3% to €153.2m during the half year. Stripping out acquisitions and currency effects gives like-for-like figures of +17.3% and €146.4m.

Adjusted pre-tax profit rose by 14.3% to €18.4m but adjusted earnings per share were only 2% higher as a result of a higher tax charge.

Annualised return on capital employed (ROCE) is reported as 19.7%, versus 17.6% last year. However, this figure is quite heavily adjusted. I’ll return to this shortly.

Trading in the second half of the year is said to be in line with expectations, excluding the impact of any further acquisitions.

Acquisitions: One acquisition is announced today – a €3.7m deal to buy a German dubbing specialist, TV+SYNCHRON. This 25-year old firm has a portfolio of television clients, including Warner Bros, HBO and Amazon. It’s also a gold-rated Netflix Post-Production Partner.

Keyword plans to expand the business into the gaming sector.

TVS is expected to generate revenue of €4.1m this year, but there’s no information about profitability, so it’s hard to say whether the €3.7m valuation offers good value for KWS shareholders.

Adjusted profit: a big production?

Keyword Studios’ adjusted profits are quite far removed from the firm’s reported figures. For example, today’s H1 results show adjusted pre-tax profit of €18.4m. Statutory pre-tax profit is 63% lower, at €6.7m.

A number of different adjustments lie behind these contrasting figures. Here’s how the company explains the adjustments in today’s results:

KWS adjusted profit definition 1H19

Let’s break this down:

Acquisition and integration expenses (€2.8m): This company’s business model appears to be based on acting as a consolidator. In the last two years, Keyword Studios has RNS’d no fewer than 15 acquisitions. On this basis, I think acquisition and integration costs should be considered a regular cost of business. I don’t think they should be excluded from headline profits.

Share option charges (€4m): These are basically a remuneration cost. I think they should be included in profit calculations, although I accept that they are lumpy and so might distort year-on-year comparisons.

Amortisation of intangibles (€3.5m): This is a non-cash expense. It relates to the cash paid in past acquisition deals for intangible assets. KWS says that its intangibles are mainly customer relationships. The balance sheet values of these assets are reduced each year in line with the company’s policy on asset valuation.

The argument for adjusting out amortisation of intangibles is that doing so provides a more accurate picture of the current cash profitability of the business. The argument against adjusting out this figure is that it represents real cash that’s been spent in prior years.

This is a very common adjustment that’s widely accepted. I think it’s a little too widely used, but in this case I’d accept it. I wouldn’t expect the firm to incur a repeat of its acquisition spend when maintaining and extending its customer relationships.

Foreign currency exchange loss (€1.2m): My view on forex costs is that in a well-run business, they will generally even out over time. So I’m happy with this adjustment.

Revised adjusted profit: Based on my comments above, I’d calculate an adjusted pre-tax profit figure of €11.6m.

As a sanity check, the group’s operating cash flow for the half year was €9.2m. So I think it’s fair to say that my adjusted figure provides a more realistic view of cash profitability than the firm’s adjusted measure.

How profitable is this business?

Let’s look at a couple of measures of profitability.

Operating margin: Using the methodology I’ve outlined above and the company’s reported finance costs, I’ve calculated a 12-month adjusted operating profit figure of c.€30m. On this basis, KWS has generated an adjusted operating margin of about 10% over the last 12 months.

I’d view this as acceptable, but not outstanding.

Return on capital employed: I’m afraid we’re back into the land of big adjustments here. Management report an “annualised return on capital employed” of 19.7% in today’s half-year results, up from 17.6% last year.

I welcome this focus on return on capital, but I’m not keen on the methodology. This adjusted ROCE figure uses the firm’s measure of adjusted pre-tax profit, which I’ve already discussed. It also uses “pre-acquisition profits of current year acquisitions”.

From what I can tell, this is then compared to period-end capital employed, not average capital employed over the period.

The end result is meant to indicate what ROCE might have been if the company had owned all current-year acquisitions for a complete 12-month period. I’d view this as a pro-forma figure that’s boosted by the heavy adjustments included in the firm’s adjusted profit calculation.

Based on my view of the firm’s profits, I estimate an adjusted ROCE of c.14% for the year-ending 30 June. I note that using a stricter approach based on statutory profit, Stockopedia reports a ROCE figure of 11% for 2018.

My view

Keyword Studios appears to be a decent enough business, in a growing sector. So far, the firm seems to have a good handle on integrating acquisitions while continuing to generate strong organic growth.

However, even if you subscribe to the firm’s version of adjusted profits, I think the shares look pretty expensive. Based on consensus forecasts for the year, KWS stock trades on about 29 times earnings.

Based on last year’s reported earnings, this multiple rises to more than 60.

I don’t see much value in this stock at current levels.

Kingfisher (KGF)

  • Share price: 197p (-2%)
  • Market cap: £4.2bn

Half-year results

Today’s half-year results from the owners of B&Q and Screwfix contained little to cheer investors. Sales in France continued to fall and B&Q revenue was also hit by disruption relating to the group’s transformation programme. The only bright spot was trade-focused chain Screwfix, where sales rose by 9.9%.

The end result was that group revenue fell by 1.4% to €5,997m, while underlying operating profit (“retail profit”) fell by 4.8% to £466m. This gives an underlying operating margin of 7.7% — not a bad figure for a big retailer, in my view.

Kingfisher’s bean counters appear to be suffering from adjustment fever and provide no fewer than three versions of pre-tax and after-tax profit:

KGF 1H19 financial summary

Underlying and adjusted profits include different permutations of transformation spending and other costs. To be honest, I don’t think it’s worth the effort of trying to work out which one is more representative.

What I would point out is that the interim dividend remains very comfortably covered by earnings, even at a statutory level.

The dividend should also be covered comfortably by free cash flow, which totalled £204m during the period.

My view

The costs of the group’s transformation programme, which aims to unify product ranges across its DIY chains, remain considerable and have totalled £537m since 2016/17. However, this challenging shift does seem to be delivering results.

According to the firm, gross margin on unified ranges rose has risen by 1.5% over the last year. 59% of product ranges, measured by cost, have now been unified.

In some ways, today’s results are just a holding statement. Chief executive Veronique Laury, who launched the current transformation programme, is leaving and her replacement, Thierry Garnier, starts work on 25 September.

It remains to be seen whether Mr Garnier will consider any more drastic changes, such as splitting the group up.

However, it’s worth remembering that despite poor trading, Kingfisher remains profitable and cash generative. It also has a stronger balance sheet than some rivals — excluding the lease adjustments required under the new IFRS16 accounting regulations, my sums suggest the group ended the period with net cash of more than £200m.

DIY chains are said to be suffering from the trend towards ‘do it for me’ — i.e. hiring tradespeople, who don’t shop at B&Q.

But the group has a strong balance sheet and a big market share in the UK. Screwfix is also a valuable, growing business.

The shares are now trading on just 9 times forecast earnings, with a twice-covered 5.4% dividend yield.

With a new CEO coming on board, I can see some value here.

British Land (BLND)

  • Share price: 566p (+1%)
  • Market cap: £5.3bn

Operational update

(At the time of publication, Roland has a long position in BLND)

Just a brief update from this FTSE 100 REIT, which I’ve been buying recently for my income portfolio.

The retail property market is deep in the doldrums at the moment, thanks to the well-publicised problems of high street retailers.

British Land’s mixed portfolio includes a lot of prime London office space and “mixed use campuses”, for which demand and valuations remain firm.

The group’s retail portfolio also seems to be performing relatively well in a difficult market.

According to today’s update, leasing activity during the five months to August 2019 generated headline rents of £7.2m, 2% ahead of previous passing rents. Retail occupancy is now said to be 97%, versus 96.7% at the 31 March year end.

Although these leases may have required sweeteners to persuade customers to sign, the firm says that footfall in its shopping centres has fallen by just 0.2% since the end of March, ahead of a sector benchmark of -4.4%.

Similarly, like-for-like sales are said to be up 1.1%, versus a benchmark of -4.1%.

My view

These numbers highlight the dire state of the physical retail sector. But they suggest to me that British Land’s portfolio remains at the top end of the quality spectrum. With the shares trading at a 37% discount to NAV and yielding 5.6%, I remain a long-term buyer.

That’s all for today. I’ll be back with more midcap news tomorrow.



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Wordpress (2)
  • comment-avatar

    I note that where I live there are only two DIY stores :- B&Q and Hombase ( or what ever they call it now) . Home base has suddenly got quite expensive for staples of home DIY and the car park is often deplete compared with B&Q ……if that is any help to potential investors . A complete reversal of the situation a few years ago in my particular town.

    • comment-avatar

      Hi wildrides,

      Interesting comment – my experience is a bit different. I’ve always found Homebase to be more expensive than B&Q, which is generally well stocked and fairly priced.

      However, our local Homebase closed some time ago and since moving house a few years ago, our nearest B&Q is about 20 miles away.

      Instead, I shop at the local builders merchant, online and in one or two old-fashioned stores that still stock ‘hardware’. It’s more fun and can be cheaper than B&Q, but sometimes requires one to be a more informed buyer.


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