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Tencent bets £40m on UK video game shares. Here’s what I’d do now

Chinese internet giant Tencent is hoovering up UK video game shares and for good reason.

For the past 10 years the $390bn conglomerate has been spending its ludicrously large venture capital on the world’s biggest games, from Call of Duty through a minority stake in Activision Blizzard, to 2018’s most profitable game Fortnite, as it owns 40% of publisher Epic Games.

On 15 November, the WeChat owner snapped up a 9.9% stake in AIM-listed studio Sumo (LSE:SUMO). Sumo’s share price rose 8% when the news hit the market.

Game on

The UK games market was worth a record £5.7bn in 2019, with mobile and multiplayer games showing the fastest growth. And in February this year, Sumo opened a new Leamington Spa studio to focus solely on mobile gaming, which I think is a very good decision.

FTSE-listed video game developers used to be rare. Now we have Team 17, which is profitable and beating expectations, and racing specialist Codemasters that recently extended its exclusive rights to produce F1 games until 2025.

As I predicted the 5 November release of Frontier Developments’ latest blockbuster tycoon game Planet Zoo has helped its share price climb 10%.

In fact, Frontier’s share price is up 450% in the last three years. In 2017 Tencent took a 9% stake worth £17.7m in the Cambridge game studio. Coincidence? I think not.

But I’d say there is more upside coming from this next China-favoured choice, if you can get it at a decent price.

One quick note: invest using a Stocks and Shares ISA or a SIPP and you’ll shield your gains from the grasping hands of the taxman.

Wrestling a profit

Sumo is generating big wads of cash and will only get more profitable, in my opinion.

Founded in Sheffield in 2003, this games co-developer went through three changes of ownership as private equity piled in for its high-growth strategy.

Then the company deleveraged, using cash raised from its 2017 AIM float to clear debt from its balance sheet. This is a smart move which has paid off, with more profit coming from its £38m a year revenue instead of being siphoned off elsewhere.

Follow the money

2019 half-year results out on 26 September show a company in very good financial health, with net cash of £8.9m, gross profits up 13.7% to £9.8m, and margins rising 3% to 46.3%.

Sumo’s own IP makes up a relatively small proportion of its revenue. In-house game Snake Pass sold 170,000 units for a reported ROI of 83% but is now more than two years old, but bosses have indicated they wants to go much further down this line. Paying out less in royalties and licensing fees certainly makes sense to me.

In the past couple of years Sumo has also expanded hard to maintain growth. 2017 design studio acquisition Atomhawk generated £1.5m revenue in the first half of 2019, while its last two buys The Chinese Room and Red Kite Games pulled in £1.1m.

Don’t just listen to me. Follow the money. First the profits, then the growth, then the billion-customer-strong Chinese money.

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Tom owns shares in Frontier Developments. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.