It was another good set of results that G5 Entertainment reported on Friday and most importantly, the comments around the start of 2012 were positive and the 2012 target of an EPS of SEK 3.20 was reiterated. Also, CEO Vlad Suglobov states in the report that he wants to be more conservative in the future with his guidance and at the same time he is sticking to the 3.20. I guess this means that the SEK 3.20 should be considered to be conservative.
Nordic Investor got hold of CEO Suglobov for a few follow-up comments on the report:
Nordic Investor: Can you talk a bit about your investment activities and how this affected the Q4 result?
CEO Suglobov: If you are referring to cash flow, then this is according to the plan we were trying to communicate for a while now. We did not raise money from Traction just to dilute shareholders. We raised the money in order to invest the money, and investing money means spending money on licensing and developing new games. Hence negative cash flow and increased development costs on the balance sheet. We raised money in Q3, and invested actively in Q4, so it’s all natural. In 2012 we will see the results of this investment — the increased number of game releases. The management is watching the cash flow and our cash in bank in order to maintain sufficient safety cushion. We are in control of our cash flow. We can turn the company into cash flow positive very fast by slowing down the growth of investment in new products. However, our goal right now is to reinvest and ramp up the production for the sake of future growth. The market is growing fast and we need to grow fast to keep up with the competition and seize market share.
NI: Your tax rate was rather high at 26.9% during Q4. You mention in the report that it is due to the international structure with different tax rates. What has changed in your structure that makes this a bigger issue than in the past? What is a reasonable tax rate to calculate with going forward?
CEO: Taxes are paid based on a company’s annual results. It is not accurate to measure tax in a single quarter — this is only an approximation. One needs to look at the whole period January-December. If you look at it, you will see that our effective tax rate was circa 21%. The change from 2010 to 2011 was that we moved our development studio holding companies to Malta in order to optimize group structure and keep our development and publishing holding entities within EU. This was communicated in the company reports well in advance. The tax rate is rather high because Swedish corporate tax rate is rather high. It is impossible to say precisely what is the tax rate we will see in 2012, but you can look at 2011 as a reference point. Also, we do not consider having to pay taxes an issue — it is what any responsible business has to do.
NI: The decrease in operating receivables in Q4 was large at SEK -3708m. What happened there?
CEO: Accounts receivable can move up and down — this is normal in the course of business, and depends on when our distribution partners remit their payments to G5. Our revenue comes from large companies like Apple, Google, and Amazon. Their payments come within certain period of time after the end of the reporting period. Sometimes their payments arrive earlier than at other times. Comparing two such situations you will see a difference in Accounts Receivable, which can be comparable to the group’s monthly revenue.
Finally, for everybody still wondering about the legitimacy of G5 Entertainment’s approach to capitalize its development costs and how this is boosting earnings short-term we highly recommend to read our interview with CEO Suglobov from November 18th, 2011 (http://nordicinvestor.net/2011/11/18/g5-entertainment-ceo-comments-2/).
It is quite obvious that a company should be judged and valued by its future potential rather than its most recent quarter. Naturally, a company that has sales of SEK 46m needs to invest in its growth. In fact, that is what its owners expect from it. So judging a company by yesterday’s cash-flow maybe makes sense for an established and mature business but certainly not for a growth company. Rather, investors have to look at the market the company is active in and how it manages to grow its sales, i.e. how the company is holding up in the market place. Needless to say, G5 Entertainment is doing exceptionally well in a very fast growing market. Their games are assets, which is why they belong on the balance sheet. Would 2011 earnings have been lower if G5 treated its development costs as expenses? Absolutely! But these developments costs create long-term value for G5 and its shareholders. As long as they lead to revenue growth in the future, this is absolutely desirable. G5’s track record speaks for itself and Supermarket Mania, the company’s first game released for the iPhone in 2009 is still generating revenue despite the fact that is completely depreciated since almost one year ago.
So what does this mean for a valuation approach of G5 Entertainment? Actually, the issue that critics most often cite might pretty much have the complete opposite implication for a fair valuation. People arguing for 2011 and also 2012 earnings to be “too high” (as in “boosted by activated development costs”), forget in our opinion that the revenue line is what it is, i.e. is not “artificially high”. Furthermore, a boosted earnings line in 2012 implies even further revenue growth in 2013, since all the development costs of 2012 will lead to new games in 2013. The question is rather when a “steady state” is reached and what that will look like. In a steady state, G5 will invest more or less in-line with depreciation which makes earnings “clean” which leads to “clean” cash-flow as well. This has to be a clear target and needs to be followed closely by shareholders. Ultimately, shareholders will want to be rewarded with dividends and those can only be paid with cash. However, such a steady state is hopefully many years in the future as the smartphone and tablet markets have much much more growth to give and G5 has much much more growth potential by entering new platforms, new genres, simply publishing more games etc. So a fair valuation approach is most likely not the one we use most often, i.e. looking at 12-months forward EPS and applying a PE-ratio on that number. A fair valuation approach would be to judge how such a steady state will look like for G5. I am willing to bet that it is much much higher than 2012 levels and that a fair valuation for G5 is much much higher than the current enterprise value of around SEK 335m.
Good luck everyone!