Recently, there have been some discussions in the market about the legitimacy of G5 Entertainment’s accounting methods. While the intentions of certain discussions can be sometimes questionable, we do believe that it is always healthy to scrutinize a company and to try to understand it as good as possible. Therefore, we took these concerns serious and wanted to get management’s take on things. In our opinion, G5 Entertainment’s management is nothing but very professional and ahead of the curve. CEO Vlad Suglobov has been leading the company for several years now and managed to transform their strategy. As a major shareholder of G5 Entertainment (Mr Suglobov holds almost 10% of the capital) we are convinced that his interests are very much aligned with the average private shareholder’s.
G5 Entertainment’s CEO Vlad Suglobov comments:
“To start with, we have proven that G5’s game publishing business model is a cash generator when the portfolio of games is big enough. In Q4 2010, G5 has generated positive cash flow of 2.6 MKr on revenue of 8 MKr, in Q1 2011 – 3 MKr on revenue of 9.5 MKr. G5 can easily manage its cash flow. More investment brings more growth in the near future, but puts pressure on cash flow in short term. Less investment means more cash immediately but reduces expected growth. This cash flow/investment balance happening within G5 is important for shareholders to understand. And we believe that capitalizing development costs and depreciating them over 2 years term is the best way to provide the correct picture of our business to the shareholders, because it shows the amount of investment in new games being undertaken in the company.
When we are buying a computer for our engineers to use, we are not writing off the costs of acquiring this computer immediately, but depreciate it gradually over a period of time. If we did write off computers immediately, we would give shareholders an incorrect picture of the company. The company would own computers worth certain amount of money, while they won’t be on the balance sheet of the company, and the cost of computers would be treated as a loss. All while the company would continue to own computers that maintain certain resell value. Not showing this value would be misleading. Capitalizing the cost of purchasing computers allows us to show that the company owns such assets.
Similarly, games on our balance sheet have real value. I can think of at least several companies that would be interested in acquiring these games in development stage, even more so when games are complete, and even after these games were published – because of the recurring revenue stream that can continue for years on the growing market. Not surprisingly, G5 itself is very interested in selling these games and making a nice profit. It is important that we show this value on the balance of the company, because otherwise we would be treating investment in new products as an expense, and a loss – and this would be misleading.
Mathematically, for the end result, there’s no difference if we depreciate the development costs immediately or in 2 years. There is certain amount of revenue to be made by the game in 2 years, and a certain amount of costs to produce the game. The net result for any game over 2 years is going to be the same, no matter if we capitalize costs or we don’t, if we write the costs off the moment the game is published, or gradually in the next 2 years. If we were to write off all investment in new games we made during 2010, our 2010 earnings would be lower, but our 2011 earnings would be higher, because in 2011 we would have less depreciation of capitalized development costs from 2010.Similarly, if we write off all capitalized development costs right now, next year 2012 will get a boost in profit because there will be no expense against the revenue from games that we now develop. So it doesn’t matter if we write it off right now or in 2012 – the total result is going to be the same.
Capitalization of development costs allows us to show shareholders the dynamics of the investment in the company. By looking at capitalized development costs dynamics, one can tell if we are increasing the investment, maintaining the same level of investment, or cashing out while reducing the investment. When a manufacturing company invests in a new factory, does it capitalize expenses? It does. Can investment turn into a loss? Yes it can. Still, it makes sense to do it. It makes no sense to tell shareholdersthat investment in a plant is a loss as soon as the plant is ready to use. For G5, its games are like factories because with some maintenance costs they produce recurring revenue. And like I mentioned they even have resell value. It is intangible, yes. But there are many valuable intangible assets in the world, including some of the biggest brands and intellectual properties. A factory or a commercial real estate can produce a loss even though they are very tangible.
In order to judge whether or not the investment is likely to make a profit or a loss, one needs to look at the business model and the track record. As I mentioned in investor presentation in June (Nordic Investor: please find the video of the presentation under “G5 Entertainment” in the menu on top of the page) (and displayed a chart of our revenue distribution among games), G5 does not tend to have games that are hits and games that are flops. Our casual games are very consumable and our users want to play them again and again once they get introduced to them. Our users usually download and buy many of our games, over time. We have games that sell better and games that sell less, but even those games that tend to sell less recoup the expenses and produce a healthy profit. A few months ago, our first game Supermarket Mania celebrated 2 years of its availability on the App Store, and it continues to sell well into the 3rd year. It was brought to Android recently with minimum costs (thanks to our Talisman technology), and now makes money on Android. Recently, few more games passed 2 years line. Stand O’Food, Success Story, and Mahjongg games that we released in the summer of 2009 all continue to make money on iOS, and they are also available on Android now, where Stand O’Food became a hit with over 1.6 million downloads and over 22 thousand user reviews – in only a couple of months. We haven’t had a single game that passed 24 months in sales and would cease to generate revenue for G5, or approach near-zero levels. It’s just not happening because we maintain the pace with new releases, and the underlying market grows quickly.
When it comes to determining the costs that are put on a balance sheet, the board has a policy in place, and our auditors are of course aware of the fact that we capitalize development costs and they consider the policy reasonable. We can only capitalize direct development costs: the cost of work of programmers, artists, level designers, etc. who directly participate in the development of the game, the product. We do not capitalize any marketing or company management costs. So there is no “air” in the capitalized development costs, there are products that will generate revenue for more than two years, once completed and published. And we keep the budgets of our games reasonable. At the moment, our capitalized development costs represent tens of games. The capitalized development cost amount per game is rather low.
It can also be good to know that in 2011, the board introduced a cap on the total amount of top management bonus in one year. And as key managers’ interest in the company is significantly higher than their compensation in the company, their interests are aligned with those of the shareholders, and they are perfectly motivated to build for the long term and to create shareholder value. This has been demonstrated over the years the company is listed in Stockholm. Please also note that most of our development staff is located in Kharkov, Ukraine. Our Russian development office has a small staff which is primarily working on our Talisman technology, while the office in Ukraine works on games. And no – we are not connected to Ryska Maffian, but I know from movies like “The Girl with the Dragon Tattoo” about the dangers of living in Stockholm.”
No more questions from my side!