A stock to top up…and one to reduce – Small cap fund managers give their view
Top up – Keywords Studios
Keywords provides art creation, localisation, audio, testing and support services to the fast-growing video games industry, working with many of the world’s largest games and console manufacturers.
Outsourcing of these services is increasingly in demand, as their customers face up to the complexity of delivering games over multiple platforms and devices, as well as an explosion in the amount of content required for games continually being updated and improved. Meanwhile, the services market itself remains very fragmented across the globe, providing ample opportunity for Keywords to consolidate smaller suppliers as well as generating robust organic growth.
We like the business for its intellectual property and strong physical distribution network, which both provide clear barriers to competition. There is significant know-how within the employee base; the services in question need to be performed by people with rare skills, who are inherently difficult to find. The company also enjoys a leading market position, with a global footprint of 21 of the top 25 games companies as customers. Another important part of our investment process is to ensure that management have plenty of ‘skin in the game’, and the Keywords directors hold 30% of the equity.
The balance sheet was bolstered in December by a £10m placing in which we participated, leaving the company with plenty of firepower to selectively acquire if opportunities arise. We believe that it is well positioned in this growing industry and that the shares, despite a relatively heady rating, should continue to perform strongly this year.
Reduce – DX Group/UK Mail
The UK parcel carrier industry has proved itself to be in considerable disarray over the past year. Following the well-publicised collapse of City Link over Christmas 2014, the firm’s competitors scrambled for its market share, often overstretching themselves beyond maximum capacity on poor commercial terms.
After the initial fallout, investors could be forgiven for anticipating a normalisation of the industry, with fundamental under-capacity leading prices higher. So far, this dynamic has failed to materialise and instead, industry participants have been beset by further problems.
UK Mail was bitten first, in August, by overambitious assumptions on the opening of its new automated facility. This heralded the start of a 50% decline in the share price in five months, exacerbated by a further profits warning later in the year.
DX Group followed suit in November in even more spectacular fashion. The shares have lost almost 80% of their value since it warned of a triple whammy of pressures: rising driver salary costs, aggressive competitor pricing activity, and a faster-than-expected fall in the part of the business which delivers critical paper documents.
Although both businesses arguably possess the strong distribution networks which we look for, we are concerned at their apparent inability to translate this into sustained pricing power. The reported issues come in spite of the clear growth dynamics of the industry, led by the increasing trend towards online shopping. Perhaps, with time, the anticipated rationalisation will occur, but without hard evidence of this, we feel that reducing exposure is prudent despite depressed share prices.