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#G5 Entertainment: Why margins of 10-15% are just fine

newlogoMobile gaming developer and publisher G5 Entertainment released its Q2 2014 report yesterday. This was the first report released as a Nasdaq OMX listed company. The highlight was clearly the y-o-y revenue growth of 86% (even higher than previously guided for). This came despite the fact that no major new game was launched during the quarter and is a strong sign that the underlying market is growing nicely, while at the same time, G5 manages to keep the top grossing ranking positions for its most important games. G5 is currently working on upcoming new free-to-play games with the aim to have more than 10 free-to-play games (vs 7 today) in the portfolio before the end of 2014.

12mtrailingrevenuesQ2 2014 revenue from free-to-play games grew by 202% compared with the same period last year and accounted for 71% of total revenue. The accumulated number of downloads of G5 games (excluding updates) surpassed 170m during the quarter.

As our regular market updates have shown, the traditional seasonaly pattern does not apply anymore in the “free-to-play”-world. G5 management states in the report that it is “growing increasingly confident that going forward seasonality is not going to affect the revenue as much as it did in previous years.”

We were also pleased to hear that business in G5’s Kharkov office continues as usual. Critical code and materials are backed up outside Ukraine, intellectual property rights are kept in EU entities and funds to subsidiaries are transferred on a as-needed basis. The political risk in the G5 story is therefore limited, in our opinion.

G5So why then, you might ask yourself, did the G5 share close down more than 13% yesterday? The magnitude of the decline was certainly irrational, but the answer lies in the margin development. EBIT excluding re-listing expenses amounted to SEK 3.5m, implying an adjusted EBIT margin of 9%. This marked a sequentially by 460bp, which can partly be explained by investment costs in G5’s publishing platform toolset. The tools are designed to make the development, deployment, performance analysis and marketing of free-to-play games more effective, enhancing the ability of the development teams to focus on creative aspects and achieve targets for usage, engagement and monetization parameters. Talking to CEO Vlad Suglobov, we got the impression that these costs should, however, not be seen as one-offs, since they are mainly related to an increase of staff, which is permanent.

Despite the sequential margin decline, G5 reiterated in the report that it expects to return to 30% margin levels over time through organic top-line growth. It remains unclear what underlying revenue level is required in order for management’s target to be met since we believe that increased revenues go hand-in-hand with increased marketing efforts.

Given the fact, that the underlying market is steadily improving (see our latest market update here), combined with the upcoming release of new F2P-games, we are optimistic that G5 will be able to increase its revenues in H2 versus H1. For Q3 and Q4, we are now assuming a sequential revenue increase of 4% and 6% respectively, which leads to a FY 2014 revenue estimate of SEK 167m. This implies a y-o-y increase of 67% and must be seen as very impressive, even by the worst critics out there. In our updated scenario, we are now incorporating the higher fixed cost base. However, due to the expected sequential increase in revenue we believe G5 will be able to increase its adjusted EBIT margin from 9% in Q2, to 10.6% in Q3 and around 13% in Q4.  This leaves us with an updated 2014 EPS estimate of SEK 1.69.

The transition to a F2P-player has been successful. The F2P-space is different compared with the original mobile gaming space and requires increased marketing cost. We are therefore not 100% sure that G5 will manage to return to its previous EBIT margin levels of 30% and more. However, we argue that this is not necessary either. At the current share price of SEK 28.3, G5 is trading at roughly 17x our updated 2014 EPS estimate. For a company that is expected to grow sales by 67% for the FY 2014, this is certainly not ambitious at all. Furthermore, we believe that growth will continue into 2015 and beyond, both due to an increasing market and a larger games portfolio that will start to monetize in earnest during 2015. Prudently assuming sales growth of 25% for 2015, and an increased EBIT margin (due to the operational leverage) to 15%, we would end up with a 2015 EPS of just below SEK 3. This means that G5 is currently trading at a 12m-forward PE-multiple of 9x. This is very very cheap! In comparison, US mobile gaming developer Glu Mobile, is currently trading at 22x expected 2015 EPS.

So once again: an EBIT margin of 30% is not necessary whatsoever. 10-15% are perfectly fine, with sales growth being so stellar as it is.

On top, investors also get an option that one, or more, of G5’s games will become a smash-it with top grossing rankings of 20 and better in the most important US iPhone and iPad stores. Then, margins of 30% and more are certainly more than possible.

Nordic Investor

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