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Game on

Power up your portfolio with the UK's thriving video games companies as global spending climbs steeply and the model changes from boxed product to recurring service
Game on

Mention 'gaming' to UK investors and their first thought will probably be gambling operators such as Ladbrokes and 888. Specify 'video games' and, after racking their brains, they might just suggest Sony or Nintendo. Few will be aware of the UK's thriving video game industry, which features companies that make and sell the titles, provide motion-capture cameras, test the games and host tournaments watched by millions.

Their strong growth prospects and relative obscurity give investors an excellent way to power up their portfolios.

Famed TV and film companies such as Sky, ITV and Cineworld often hog the headlines in the entertainment space, but the scale and momentum of the video game sector is equally striking. Analysts at PwC predict that global spending on video games will climb around 6.2 per cent annually between 2013 and 2018, to $89bn (£57bn), outpacing expected growth in spending on both films and televised entertainment. In the UK, they forecast spending will rise about 5.1 per cent a year to £4.1bn in 2018. Video games are also grabbing domestic advertisers, whose spending is slated to rise around 12 per cent a year over the same period.

Those robust growth forecasts partly reflect the global proliferation of smartphones and tablets, which has taken video gaming out of teenagers' basements and into the mainstream. More and more people can now play games without purchasing a dedicated device, and have easy access to thousands of mobile games through Apple and Google's app stores. They've leapt at the chance: two-thirds of the 100 highest-grossing mobile apps are games - led by Candy Crush, Angry Birds and Clash of Clans - and the mobile games market is forecast to double in size between 2012 and 2017 to $35.4bn (£22.7bn).  

 

A gaming revolution

Video games are also moving from a boxed product into a recurring service. More and more developers are charging monthly subscription fees, offering in-game purchases and delivering a steady stream of downloadable content and updates in the months after launch. That extends shelf life, provides recurring revenue and allows studios to fix glitches without pricey recalls.

Many of the major developers are based in the US or Asia, but the UK is far from a laggard. It boasts more than 1,900 video game companies, says trade body UKIE, and that number grew 22 per cent a year between 2011 and 2013. Edinburgh-based Rockstar North created Grand Theft Auto V, which racked up $1bn in global sales within three days and holds the crown as the highest-grossing entertainment product in history. Rocksteady Studios in London has set a new standard for superhero games with its acclaimed Batman: Arkham series. And Surrey-based Lionhead Studios, which was acquired by Microsoft in 2006, makes the best-selling Fable games.

 

A steal: Rockstar North's GTA V is the highest grossing entertainment product in history

 

Some companies are playing on a higher difficulty level. GAME, which was taken into administration and delisted in 2012, returned to the London market as Game Digital (GMD) in June 2014. Although the video game retailer has slashed its store count to around 600 and cut costs, it issued a profit warning in January as fierce competition continued to weigh on earnings. Management has revamped the business to attract and retain the next generation of gamers; more than 450,000 customers in the UK and Spain now store and track their reward points, gift cards, trade-in credit and cash using the group's Game Wallet e-payment system. The group also launched an online marketplace that connects vendors to customers, providing useful insight into their preferences. And it has started accepting trade-ins of smartphones and tablets, selling more digital content and offering exclusive versions of games to snatch customers from Amazon and other competitors.

Game Digital has made other bold moves, too. It recently acquired Multiplay, which runs major gaming festivals - its flagship Insomnia event had 67,000 attendees - and offers server hosting and other services to game publishers. It should also benefit from this year's strong release schedule, which features Halo 5, Star Wars Battlefront and new versions of Fifa, Call of Duty and Assassin’s Creed. And, unlike last year, it shouldn't suffer aggressive discounting on Sony's PlayStation 4 and Microsoft's Xbox One consoles; several price cuts eroded margins in 2014, but analysts believe a more benign pricing environment is on the way (around 4.5m UK residents are expected to own a 'next-gen' console by November, compared with 2.5m in November 2014). Gamers are also likely to spend more on higher-margin games - both new and pre-owned - and accessories. Finally, a new Nintendo console could provide a boost in 2016: more than 100m of the previous Nintendo Wii were sold worldwide, making it the best-selling console of all time.

 

This year's strong release schedule features Halo 5

 

Those wont to shy away from traditional retailers and their structural challenges may find Frontier Developments (FDEV) more palatable. The studio, which has historically made games for third-parties - such as ScreamRide for Microsoft and Tales from Deep Space for Amazon - is shifting its focus towards more lucrative self-publishing. That transition is made viable by digital distribution, or allowing customers to purchase and download games directly via PCs or internet-connected consoles, says founder and chief executive David Braben. Indeed, PwC analysts predict spending on downloadable console games in the UK will climb about 12.3 per cent a year to reach £900m by 2018 - not far from the £1.2bn spent on physical console games each year.

Frontier's strategy seems to be paying off: its flagship title, Elite: Dangerous, has sold over 640,000 units at about £40 each. The group continues to add new features to the space simulator, and has expanded its potential audience by rolling it out on more platforms, including Apple Mac and Xbox One. It's also selling it through several distribution channels and localising the game for overseas players. Frontier is now developing its second self-published game, Planet Coaster.

 

Open the options menu

Some may balk at backing a single developer; Keywords Studios (KWS) offers a way to tap into the industry's global growth with a little less risk. The group provides technical services such as voice recording, game testing and translation to most of the world's largest video game companies, including Sony and Microsoft. It's benefiting from the industry's globalisation, a raft of new platforms and the rising amount of graphical and audio content in modern games. It has also made seven acquisitions in the past 18 months that have bolstered its range of services, added higher-margin art creation into the mix, and expanded the group into Milan, Los Angeles, Rio de Janeiro and Mexico City. Management is now on the hunt for businesses in the huge market for outsourced art creation and production.

Mercia Technologies (MERC) offers another way for investors to spread their bets. The technology investor, which listed on Aim in December, holds stakes in several small video game companies. Investment director Mike Hayes, a former executive at Sega and Nintendo, points to mounting interest in gaming, with no plateau in sight.

Mercia favours businesses in major growth markets such as online and PC gaming. For instance, management believes VirtTrade's platform - where users can swap digital trading cards that update based on real-world events - could be as revolutionary as Apple's iTunes or Amazon's Kindle. It also owns a third of nDreams, a pioneer in virtual reality (VR) that creates truly immersive video games. The nascent VR industry has been validated by Facebook's $2bn takeover of developer Oculus last summer, and upcoming rival headsets from Sony, Microsoft and HTC.

 

Game on: Candy Crush is one of the highest grossing mobile apps

 

Another interesting alternative might be OMG (OMG), as the imaging specialist's Vicon cameras are used for motion capture in video games. For instance, Poland's Alvernia Studios utilised them to create Gears of War: Judgement and The Witcher 2, while French developer Quantic Dream relied on them to capture the facial expressions and movements of film stars Ellen Page and Willem Dafoe for Beyond: Two Souls. The group, which works with Sega, Ubisoft and other major players, recently inked deals with Electronic Arts and Capcom.

 

A spectator sport

The industry's oddest trend may well be the surging demand among consumers to watch people play video games. More than 100m spectators tune in monthly to Twitch, Amazon's online video-game streaming platform. US authorities started granting visas to eSports participants in 2013, effectively recognising them as international athletes. And researchers at Newzoo predict the number of 'eSports' fans will soar by almost two-thirds between 2014 and 2017, to 335m, generating more than $1bn in annual revenue.

A rare play on this nascent market is Gfinity (GFIN), which organises eSports competitions. Its website, which provides league rankings and runs competitions, has nearly 350,000 registered users. The group is currently hosting a 25-week championship at the Gfinity Arena - a repurposed 600-seat section of Vue's Fulham Broadway multiplex - where contestants vie to win up to $50,000 in prize money by playing Fifa 15, Starcraft and Call of Duty: Advanced Warfare. The matches, which are streamed live on online platforms such as Twitch and MLG.tv, are on track to garner 50m online views. Gfinity also has a two-year sponsorship deal with The Sun newspaper.

A less speculative play is South Bucks-based Pinewood (PWS). The studio, where Avengers: Age of Ultron and the upcoming Star Wars and James Bond films were shot, has seen growing demand for cinematic-quality sound mixing, dialogue recording and other production services from video game developers. Indeed, it has completed sound work for Microsoft Lionhead's Fable Legends and Sega's Total War Attila. And its media investment arm, Pinewood Pictures, has started offering financing for video game production.

 

IC view: The key to winning in the video game industry is to back those companies that are successfully navigating the shift to mobile devices and digital distribution. We think Game Digital fits the bill, having found a sensible direction after a number of difficult years; broker Liberum expects strong sales of higher-margin digital content, new games and pre-owned products to offset sliding hardware revenues, driving EPS up 23 per cent to 21.4p in the year to July 2016. At 266p, the group's shares trade at just 12 times forecast earnings for 2016 and come with a lofty forward yield of 6.2 per cent.

Frontier Developments' management expects the success of Elite: Dangerous to more than double the group's revenue to over £22m for the year to end-May, generating a small operating profit. Still, we think it's too soon to assess the potential of its self-publishing model. Meanwhile, Keywords Studios is scaling up and posting strong growth in translation and localisation testing revenue, and broker Numis expects pre-tax profits to rise by nearly half to €7.5m (£5.2m) this financial year. But its shares trade at 17 times forecast earnings for the year to December 2016, limiting upside.

OMG recently sold its defence imaging business, 2d3, and its life division now licenses out its technology rather than making and marketing wearable cameras. Its remaining divisions - Yotta, which provides surveying and data-analysis tools for monitoring highways and other infrastructure assets, and Vicon - offer an enticing mix of growth and cash generation. Shares in OMG have nearly doubled in value over the past year, to 44p, and now trade at 16 times forecast EPS for the year to September 2016. But investors may want to hold off in case the new operating model suffers any teething pains.

Gfinity is cashing in on rapacious demand for eSports, supplementing ticket sales with sponsorship fees and paid subscriptions to its website. The group's current focus is on drumming up interest and becoming synonymous with high-quality events, but there's plenty of financial potential: brokerage Arden Partners expects sales to nearly quadruple to £1.9m in the year to end-June 2016, narrowing the group's adjusted pre-tax loss to £2.8m. We think it's one to watch.

Pinewood is expanding its flagship studio to cater to rising demand from film, TV and video game clients, which should boost earnings down the line. But, at 460p, its shares trade at 34 times broker N+1 Singer's forecast EPS for the year to March 2016. There's minimal value left at that rating.

After being burnt by the fallout from the dot-com crash – which saw many listed video gaming developers run into financial difficulty – UK investors haven’t recently given the UK’s video game industry the attention it deserves. However, the business of gaming has matured as quickly as the technology behind it, and yet there’s still ample potential for further innovation that could take returns to the next level.