Earnings Call: Q3 2018

Nov 6, 2018

Welcome to the 3rd quarter earnings call, G5 Entertainment. I'm Vlad Subobov, the CEO of the company. And let's begin with Slide 1. As you could have expected and as we have expected, the revenue in the Q3 was affected by the seasonally low attention from the players. This Q3 is a period when there's a lot of holiday activities and historically we've seen it comes with reduced engagement, fewer new users and overall lower activity of the players. And this has happened last year And this has happened this year again and in the absence of extraordinary growth drivers as Hidden City has been last year. And the year before that, the seasonality was more pronounced. And I think going forward, this is something that we will have to deal with every year. The when you have a game that is still early in its life cycle and it's growing really fast, you don't really notice this that much. But if the portfolio is more stable, there are no really extraordinary growth drivers, the seasonal effect is going to have an effect on the top line and the user engagement levels. And the good thing is that after the Q3, there comes a 4th quarter and the 1st quarter and these are seasonally higher quarters where people return back from their vacations and their attention goes back to the games. And so we're hopeful that we're going to see the change in the activity of players during this period of the year. And in October, in fact, we have seen that daily revenue is already higher than it was in September and this trend continues, continued in November so far. So pretty much in line with our expectations and in line with historical patterns that we have observed in G5 when it comes to how mobile players play during different times of the year. And the most important thing that continued to happen in the Q3 is that a year over year growth of our own games and the revenue generated by our own games was stronger than the performance of the life of games. And this is what keeps contributing to the increase in our gross margin. So the combined growth in the quarter, 27% year over year, obviously, is a combination of the growth that we have within the licensed games and owned games. So you can assume that licensed games year over year performed worse than that whereas our own games year over year performed actually better than 27% in terms of the growth. Our user acquisition costs in the quarter were at 26% of revenue. It's slightly higher than the last year and this is actually more than we wanted to spend, I can say, and this happened due to some initiatives in user acquisition. And it probably didn't have to be this much, but we wanted to try things during the low season because you have to feel like you have to try certain things that come to your mind when it comes to marketing and we did. And we spent more than we wanted or more than I think it is justified given the lower rate of growth. And this was not out of necessity, but out of the desire to experiment and see can we do more. So we got some negative information in return and we have analyzed that. We're going to be making our conclusions from that. And going forward, again, because our portfolio is more mature and so far or thus far the highest revenue month of hidden cities behind us, we can certainly spend a lower percentage of revenue on our user acquisition efforts. And this is going to be the balance that we're going to have to work out in the next few quarters, unless of course we have substantial changes in the composition of our portfolios and new games that perform extraordinarily or something like that. But in the short term reality, we see that we have Hidden City has matured, other games are performing our own games are performing great, but they are not on the same scale as Hidden City. So the user acquisition costs as a percentage of revenue doesn't have to be on a very high level. It doesn't have to go up at least from previous quarters. Then if you look at the fundamentals, fundamental KPIs behind our numbers, the monthly average gross revenue per paying user went up 10% year over year, which is a good thing and continues this trend. That means we are more effective at acquiring paying users and better paying users and we're getting more effective at monetizing our user base. And there was a positive change also in the user audience metrics year over year. And the breakdown of the revenue by region has not really changed much compared to previous quarters. The most of our revenue still comes from North America. Asia is more or less stable, goes 27%, 28%. From quarter to quarter, Europe at 17%, rest of the world at 6%. So no major changes there. We see that this maturity of the game when it happens, it usually happens across the regions or at least across the regions where the game has been actively marketed. And so it's pretty much in line again with what we're seeing is that when a lower season happens, it happens more or less everywhere. And then during the high season, the high season wave happens across all regions at the same time more or less. So no big changes there. Let's move on to the next slide and talk about our EBIT. So the operating profit in the quarter was SEK25.3 million with EBIT margin of 7.4%. And there are 2 big reasons why we got squeezed on the margin in this quarter. One of these is that we have used this dramatic increase in our revenue over the last couple of years with the Hidden City getting to record levels to strengthen our development team. And we have increased the staff count in the company quite substantially. This end of this Q3, I think we had 500 something employees that compared to 350 last year. And that 350, I think, compares with a lower number a much lower number a year before that. So we have to use this time and the success that we have achieved to build a much stronger team, both in terms of the project teams and the teams that do not work on the projects, but they work on important tools and platforms that are used by the project teams and that are used to market the games. And with that increased cost base, obviously, when you get into the quarter where the revenue actually goes down sequentially from the previous quarter, that kind of squeezes you on the margin. And then it was amplified this quarter also by the fact that we have spent on user acquisition more than we wanted. And while the increase in our staff count is very important strategically and it's not going to go anywhere, there's the opportunity for us going forward to adjust user acquisition spending if we want to do a better profit margin. And that remains the opportunity for the future quarters, including the Q4 where on one hand, we have said many times we would like to try and do the boost with the increased user acquisition spending and try to achieve higher growth. And on the other hand, in the absence of fast growing games and having a more mature portfolio, we will have to see whether that is justified and can we really spend a lot of money on user acquisition and generate a substantial enough growth to justify that. So we will basically see how that goes and make a decision regarding Q4 based on what we see in the market and based on what we see in terms of the revenue development in November December. So EBIT before EBIT margin before cost per user acquisition was 34% and that was substantially lower than before. So it's a dip in if you look at the chart here, EBIT margin before UA, it's kind of a seasonal dip that we had last year as well, but it's more pronounced this year. And as I mentioned, the U. A. Spend probably didn't have to be this high. So at least a part of this reduction is not permanent. Then the gross margin have gone up 52% and that again happens because a larger and larger percentage of our revenues generated by our own games where we do not have any revenue share with external developers. And this is a very positive trend and our own games continue growing year over year and they consistently do it faster than the licensed games for quite some time now. And we're optimistic that we can continue this. And the growth from our own games is going to compensate for at least some revenue that we may not have at least a part of the growth in revenue or part of the revenue that we will not have because Hidden City is a more mature game. And not to say that we're going to stop working on Hidden City, of course, because this is our main revenue generating game at the moment. And looking at how long the secret society, for example, has been in the market, we can say that Hidden City may only be through 1 third of lifetime earnings. And the developer in Kieben City, they're a very talented team, which is also very persistent. And I think they can do a great job of extending the lifetime of the game and we will do everything we can to support that. So I think the Hidden City is going to be with us for a very long time and we'll continue generating money for the company in a very long time. And in addition with that, and it's not even an addition, it's the core thing what we do, We will continue to work on our portfolio of games to improve the existing games and to create new games with the ambition to create what we can call a new hidden city, but what really is a new very successful game that hopefully overcomes the threshold that the Hidden City has set for the success of our game in our portfolio. The Hidden City, in its peak month, Hidden City has made about 4 times the revenue of the peak bonds of the Secret Society. So that's the kind of progression we have seen from our best game to our next best game in a few years. And obviously, we'd like to repeat this again and this has happened several times. So The Secret Society has made way much more money than Virtual City Playground, our previous free to play game that was very successful for G5. And now we're definitely looking forward to creating a game that will exceed the success of The Hidden City. And in the process of doing that, we will probably create other games that are going to be more successful than The Secret Society and more successful than Virtual City Playground, but maybe not as successful as Hidden City. It's a portfolio business and the most important thing here is to have strong teams and the fundamental platform for achieving the success. And then you have to place your bets carefully. And you don't really know which ones are going to play out in the long run, but you have to focus on each of these and make sure you give them enough attention to realize their potential. And that is I've been saying this for many years that we are a portfolio business that sometimes gets a very successful game. And when we have that, we run with it for as long as we can, but we never stop working on our other games with the ambition to create more successful games in the future. Let's move on to Slide number 3, the cash flow. The cash flow in the quarter was negative, about minus SEK10 1,000,000. And there were 2 big onetime items. One is the payment of the tax in Malta and another is a catch up payment of a onetime payment of Japanese VAT for years 20 20152016. So in the absence of any of these, we would actually be about 0. And then one of the delayed payments from our distributors, if that arrives on time, would actually make us positive. So fundamentally, we still have stable and healthy cash flow from operations. But of course, if you look at the capitalized development costs, they have increased substantially because we are spending more time and money on developing our games, the existing ones and the ones that did not come to the market just yet. And the amortization is catching up with capitalization with some lag obviously. And you can see it in our cash flow statement and that is also a reflection of our focus on our existing games and the future games that we are going to bring to the market. And as I mentioned, we have a runway of several years in front of us, at least several years with the human city performance and strong performance of our own games that also continue growing year over year. And we are self sustained cash flow positive and a profitable company with a number of games on the market and a growing portfolio of own games in the market and the number of games in development that we are excited about that are going to come to the market until the end of the year or early next year. And I think the company is in a better position than it ever was. And we are also in the short term speaking, we are in the exciting time also where the highest part of the year, the most active part of the year in terms of our players is right in front of us in the 4th and the first quarter. So with that, I think we have ran out of slides. So if you have any questions, please go ahead. Thank you. And we have a question from the line of Oskar Eriksson from Carnegie. Please go ahead. Operator, your line is open. Thank you. Good morning, Vlad. Yes, a few questions for me. First of all, you spoke a bit about the trend of Hidden City and more mature games. Do you feel the seasonality has been more pronounced this year than previous years? And do you have a feeling for why that could be? Is it weather related? Thank you. All right. So yes, the thank you for the question. So basically, the way it works, if you have a game that has not been exposed to large audiences and you are working from the lower base, then you don't really notice the seasonality, because if you're trying to move your game from, I don't know, 100,000 players to 500,000 players, even in the seasonally low quarter, you will still find that many new players, especially if nobody not a few players have played this game before. So early on when you have a fast growing game, the seasonality is not an issue. It becomes more of an issue when quite a few of your potential players have seen the game already or have seen the ad already, maybe played the game already. And then the seasonality, when these players move over to other activities, that creates kind of a gap in the activity that you see in the game. And when you reach out for more players, they're also more absent, so it's more difficult to reach them. And if you take if we take a fully mature product where theoretically you're not even able to gain new users, but you have an established audience, well, if their activity lowers by 20%, 30%, you'll just see that happen and then you can't really do anything until they come back and their activity restores. So it's the seasonality the effect of the seasonality is a function of how many new users and how easily you can acquire. And it's much easier for the game that is exhibiting signs of success and but doesn't have a large audience in the very beginning of the lifecycle. But it's much difficult to do when the game is mature and you kind of went through all the players or potentially all the players that could have played the game and then you have more difficulty finding the new ones. So that's just a natural function, I think, of how a game propagates through the audience, through the potential audience of the game that as the game matures and the seasonality becomes more pronounced. That to me, that makes perfect sense. The question, of course, is what does it mean a mature game? Does it mean that there's a ceiling and we cannot really go above the ceiling? And we have this chart that I've used in the presentations for a long time where we would show that as we grow the game, it can hit the ceiling and then 2 things can happen, either we find a way to improve the game and then it goes on to the next ceiling where we improve the marketing and the same thing happens or if nothing helps at some point, then the game slowly, very slowly kind of goes down, but over a very long time creating a long tail of revenue. Which of these scenarios is going to work out with Hidden City remains to be seen. I can but in any of these cases, as the game is more mature, I'm sure it's going to be modulated by seasonality in a more in a stronger way. So even if the game is going to continue growing year over year, it's probably going to have to settle during Q2, Q3 and then it's going to go up again in Q4, Q1. And that is the kind of a behavior that you can expect from more mature gains even if they go up year over year. And to completely disregard seasonality in Q3 and just go through it as Hidden City did 2 years ago, that would take a very successful game in very early stages of life to achieve that kind of thing. I hope I answered. Yes. That was very helpful. And also looking at the KPIs here, I'm a bit surprised by mix in the KPIs, if you will, that the MAUs is actually quite resilient and the monetization is lower, which is sort of breaking a trend from many quarters back. Can you explain that difference? Because I would have thought that MAUs would have declined more and the monetization a bit more stable or even sequentially? Yes. Well, you know, each of these KPIs is a function of several factors. And for example, revenue per paying user has at least two factors in it. 1 is the core audience that is playing the game, how much they are paying. And if you look at the established audience for the game, if they're more distracted during the lower season, it might happen that they end up spending less in the game, especially if the event during this period of time does not resonate as much with them as some of the holidays or just events that run during part of time when they're not on vacation. On the other hand, the revenue per paying user also is kind of moved down by user acquisition efforts because the more early stage players you acquire, the lower you push the average monetization per user because you bring in more users who are in their early stage of monetization. And acquiring users in Q3 is tricky because they are not very high paying users statistically. So this spending a lot of money on user acquisition in Q3 kind of brings down or can bring down your monetization. When it comes to the monthly active usage, it's the same situation. On one hand, you have an established base, but it's distracted, so maybe not as many people run the game during the month. On the other hand, if you were spending a lot of money to acquire new users in the quarter, this can increase your monthly active usage just because of all of the players that you brought in that may not even stick in the long run. So I think with the not very significant changes year over year, it is difficult to say what which exactly I mean, which combination of factors exactly has happened here. So for me, these numbers is more of, okay, this is what we had on average in the quarter. It makes sense. I can see how it can happen. And I don't see any red flags there really other than some metrics that probably confirm the long term trend that we understand is happening. At least I don't see that these numbers say something else or something otherwise. We obviously will continue to monitor them into Q4 and we'll see how Q4 and Q1 are going to look like. And then whether that is consistent with our view, we'll confirm that or if we're going to need to change the narrative or understand something else is happening, we'll see. But it's difficult to judge just on 1 quarter. And I don't see anything very contrary to what we've been saying before. Okay. And I mean, the secret society, as I take it, has been a bit of a disappointment so far this year. Obviously, you have written down the purchase price a bit. Can you just explain what the problem is there? And if there's what the outlook is for actually improving it? Or should we expect more of a stable or actually declining revenue pattern going forward? Well, the secret the investment in purchasing the secret society is going to be a financial success for the company and that's what I was trying to say in the report. So the price we ended up paying for the game is even lower than we have announced initially. And in any case, this is going to be a very positive thing in terms of an investment in purchasing the game. There are certain issues with the game that we've been working hard on fixing and you can just go to the application store and go through the complaints that people have. It took a while to assemble the team that can perform effectively on the game. And this team has been making some updates and they had to take over making the updates for the game and then they had to dive deeper into more fundamental issues with the game and fundamental architectural design decisions that were made in the game that are probably not helping right now. So they had to go through it and to do a certain amount of work and it took some time for us to get this team up to speed. And I think we have very good changes coming to the secret society and the players of the secret society and we're really looking forward to improving the game and giving this very loyal player base the game that they deserve and we expect that they will want to stick with the game for longer. And the game has actually been very resilient in the marketplace. If you were looking at the chart positions, for example, let's not forget that the overall market is growing. So if you continue to maintain the same chart positions, for example, year over year, that means that you're probably growing in line with the market. And if you have more or less the same revenue, what happens is that you gradually slide down the top grossing ranks. So to me, the secret society is showing just how long a successful free to play game can continue to stay strong in the market. It has been launched more than 6 years ago now. In fact, it was 6 years I think around now, I think the game launched in the beginning of November 2012. So it was 6 years already and the game is still going strong and its revenue the game's monthly revenue is not very far from its peak level. You can't say that it went down from the peak monthly revenue to some really low number. No, it is still surprisingly strong several years, I believe about 4 years now after its peak monthly revenue. What excites me about this and our efforts to keep the game going is because we are learning very important information about just how long we can keep a successful game alive and performing strongly in the market. And that every extra month that we get out of the secret society while maintaining its revenue, we can apply that to our understanding of how Mah Jong Journey is going to perform many years from now or how Hidden City can perform many years from now. And that really makes me feel good about the portfolio performance in the company. Okay. Thank you very much. That's it for me. Okay. And we don't have any further questions registered. So I'll hand the call back to the speaker for any closing comments. All right. Thank you very much for participating in our call. And that this concludes it. Thanks again.