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Sumo Group Plc - Playing for Keeps

Writen by Ed Stacey

HIGH GROWTH RATES

Sumo Group (LON:SUMO) provides creative and development services to the video games and entertainment industries, through two main operating businesses: 1) Sumo Digital, representing 90% of group revenues, is a key co-development partner and turnkey video games developer with a history of working with blue-chip clients such as Sony, Microsoft, Sega and EA (among others); 2) Atomhawk, representing 10% of group revenues, is a visual design company servicing the videos games and entertainment industries.

These end markets are both experiencing strong growth. In this report (p2) we provide a snapshot of these growth dynamics.

Sumo Group (LON:SUMO) reported full-year (FY) 2017 results on April 24, beating FY 2017 consensus, and leading to a consensus upgrade for 2018. Importantly, with revenue growth of 40.0%, the company confirmed that it is capturing more than its share of the end-market growth. Our forecasts (table below) do not include potential future acquisitions, which could boost the numbers further, in our view.

LOW RISK BUSINESS MODEL

Sumo Group presently derives more than 90% of its revenue from developer fees, paid in the main by the large video games houses. This means there is a low degree of project risk, as payment is not contingent on the commercial performance of the game.

Furthermore, there is a low capital expenditure requirement, and good payment terms benefit working capital. The company delivered cash conversion (adjusted earnings before interest and tax, or EBIT, into cash from operations) of 120% over the last two years. While we expect some reversal of working capital to reduce cash flow in 2018e, we nonetheless expect a strong cash flow trend going forward, allowing the group to continue to maintain a positive net cash position on the balance sheet.

VALUATION

Listed companies in the video games space tend to command high valuation multiples, due to the growth dynamics of the industry. There is scope for Sumo to re-rate to a higher multiple, in line with peers (see p2). We argue that, given its strong growth prospects, limited risk business model, and strong cash flows, Sumo Group offers an attractive valuation at current levels.

The chart above shows the growth in video games spending globally in recent years. Sumo Group has the capability to develop games for all types of device, with a strong position in console games and scope to grow from a smaller base in the phones/tablets segment. Perhaps more importantly, the 2017 revenue growth of 40% (33% excluding acquisition) demonstrates that the company is growing over and above the industry trend.

PROFIT GROWTH, VALUATION DISCOUNT

The chart below left shows Sumo Group’s profit growth trajectory, as measured by adjusted underlying earnings (EBITDA); profit before tax or earnings per share (EPS) would show the same trend. This is an important part of the investment thesis – Sumo Group is growing not just in revenue terms, but also in terms of the bottom line and cash flows.

The chart below shows the valuation multiple for Sumo Group, in terms of price/earnings (P/E), compared with the only comparable UK listed names. We believe that Sumo Group is carrying a newcomer’s discount, having only floated in December 2017. We believe that as the company establishes a track record in investors’ eyes, there is scope for the shares to be driven higher by multiple expansion, as well as by EPS numbers growing.

 

 

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