Sumo Group Plc (LON:SUMO) is a market leading, independent global video games co-developer, who has deep long-term relationships with the world’s largest publishers that enables them to provide full turnkey solutions for AAA games. The core business has stable, long term revenues based on a premium games development service, a formidable track record of delivery and high utilisation rates. The business currently trades on an EV/EBITDA of 15.1x and P/E of 22.3x to December 2018, an attractive discount of c.41-45% to the average of the UK peers. We see significant upside potential to forecasts from royalties and own IP development revenue streams. Post the December 2017 IPO, management and senior employees hold c.22% and Perwyn own c.28% of the enlarged share capital, with both subject to a 12 month lock-in.
Forecast market growth is impressive. The video games software market is estimated to grow 9% CAGR from 2016 to 2021, with co-development growing even faster. This growth is being driven by the ever-increasing complexity, digitisation and iterative new hardware from Microsoft and Sony providing forward compatibility for previous games.
Unique market position. Sumo is led by the founder management team who over the past 14 years have forged deep industry relationships based on quality, delivery and trust. The group is a leading Global independent studio that has the capability and expertise to work with major publishers such as Microsoft, Sony and Sega on AAA game franchises.
Visibility of order book de-risks forecasts. With a high level of subsequent year visibility every December, the order book gives a degree of comfort not enjoyed by pure IP game development studios. Typically, by December, over 60% of the following year’s forecast revenues are contracted or near contracted (for FY18 it is currently 76%).
UK staff attrition is low at mid-single digit historically. Employees are encouraged to move across titles and to create their own ideas which can be incorporated in co-development and, going forward, in an incremental fashion, solely owned IP. Utilisation rates are typically north of 90% (staff utilisation was c.94-97% over the last three years).
EBITDA margins are attractive at over 25% but can go higher. The core co-development business commands premium pricing, such is the importance of the work to the publishers. With further scale there is a degree of operational gearing but also new royalty streams and a relatively modest foray into own IP can provide further appreciation, in a low risk yet high potential reward scenario.
Our forecasts do not fully reflect the revenue growth and margin opportunity. Although we forecast core development sales growth of 27% CAGR FY16-19, this is based on employee growth rates and price appreciation materially below that enjoyed historically at Sumo Group Plc. We have been cautious in our royalty and own IP game expectations, by assuming only very modest successes in FY18 and 19, again much less than Sumo games have ultimately sold in the past (the first own IP game has generated an 84% ROI since launch in March 2017). Our adj. EBITDA margin forecast allows for a 30% CAGR.
Pre-Close Trading Update. Today’s trading statement states management expect results “at least in line” with their expectations for FY17.
Attractive Valuation. The current valuation implies an attractive discount of c.41-45% to the average of UK peer group multiples. In terms of the global peer group, when we adjust for capitalised / amortised R&D to reflect a more “cash“/underlying EBIT basis, the discount is c.25 to 37%. This is all based on what we believe are prudent forecasts. Our indicative multiples based valuation points to a figure of £212m, while our DCF results in an equity value of £202m, 25-30% above the current valuation, based upon modest WACC and growth in perpetuity assumptions.
