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#G5 Entertainment: Focus on topline

Sweden listed mobile gaming developer and publisher G5 Entertainment published its Q4 2014 report on Tuesday, February 24th. Revenues of SEK 57.7m were up 101% y-o-y and stronger from us expected, while EBIT excluding non-recurring items of SEK 2.9m once again came in below our expectations. Despite the significant sequential revenue increase of 29%, the adjusted EBIT margin increased only 70bp sequentially to 5.1% in Q4 2014. Elsewhere, there was little in the report that surprised in either way.

G5’s CEO Vlad Suglobov states in the report that the focus on effective marketing continues to benefit the company. Investment in user acquisition (UA) enables fast topline growth, but it does obviously put pressure on profitability. According to G5, users acquired in a given month, will generate a return on that UA investment over an extended period of time, usually for months and possibly years to come. We believe that this remains to be seen. Consumer loyalty in mobile gaming is at least questionable, in our opinion, given the vast supply of games and constant flow of new games. While we certainly appreciate the rapid topline growth, which was actually ahead of the market growth during 2014, we hope to see a better balance between growth and profitability going forward.

Today, www.introduce.se published an interview with CEO Vlad Suglobov:

Q: Can you please comment on the growth in Q4 and why your growth was somewhat higher than your preliminary one?

VS: The growth pace in Q4 is a result of the chosen strategy to focus on achieving the highest possible organic growth, while the opportunity is available. We have been talking about it for some time, that our increasing investments in marketing are fundamentally profitable and lead to faster growth, and Q4 results prove that point. It takes some time to monetise users we are acquiring. It takes effort to acquire and retain the right kind of users and to do it in a fundamentally profitable way. To me, Q4 results validate both the strategy we have chosen and the method we are using.

As one can probably see from the report, by looking at substantial growth with thin profit and cash flow margin, the management now has a very good control of the company’s profitability and cash flow. We have very substantial monthly marketing budget at this point, covered fully by the cash flow from operations. These marketing costs are a variable cost, at management’s discretion. Part of these costs are marketing costs that replace the players that naturally fall off from our audience in the normal course of business. And another bigger part are the costs that bring in even more players. Think of this latter part of marketing expenses as a throttle pedal. We could push it even further and go into negative cash flow and profit, in order to speed up the growth even more. Or, we could ease up on the throttle, and immediately improve the margins and the cash flow, at the expense of the growth pace. I can argue that even substantially easing up on throttle and reducing UA expenses will not lead to declining sales, as we are still acquiring the large number of new users organically, through the exposure in the application stores. This throttle of marketing expenditure can be adjusted on a day by day basis, so there’s a great degree of management control over this “throttle pedal”. What we choose to do is accelerate this company at the optimal pace, so that we could do it organically. As I mentioned in the report, it is our chosen strategy of the moment to not go into substantially negative or positive profit/cash flow zones, but to maximize the growth through organic means. And I think Q4 results is a great demonstration of how it works.

Our preliminary sales information is not precise by nature. By the time we provide this information, we have a good understanding of how the sales look like, but we still don’t have the very final reports. There can be discrepancies, therefore, and it’s normal. Substantial last minute changes in the exchange rates can also affect the outcome, and I believe this was one of the major reasons in this case.

Q: Excluding turnover and profits, what is the biggest gain from the increased number of players and usage of your games?

VS: The driver of the revenue growth are sales of F2P games. The growth of F2P games revenue is driven by the underlying growth of the active user audience, and the underlying growth of monetisation per user, and user retention. The active user base is growing due to our marketing efforts. The monetisation per user is growing both through the focus of the marketing on acquiring fundamentally profitable users, and through the efforts of the development to continue improving games through regular updates. In our case higher revenue is a key to the possibility of higher profits, as we can increase the sales of our games without increasing underlying fixed costs of the company. In general case, the cost of acquiring new users needs to be kept proportional to the revenue, but the cost of producing new content and improving the game is pretty much fixed as monthly burn rate.

Q: You discard your margin ambition of 30%, which is reasonable considering your new turnover reporting including provisions. Can you comment why you didn’t lower the ambition instead of removing it?

VS: As I explained in the report, both the board and the management want to make G5 a bigger company, and we believe this is in the interests of the shareholders. Being a larger company, with larger audience, has a number of important advantages, including the possibility of higher profits and profit margins. G5 is in the unique and very good position right now. The company can grow fast organically, the management knows how to do it, and shareholders can see from Q4 results that it’s working. It’s not like this is something every other company in this business has. Some other companies are actually struggling to achieve any growth, by any means. We have to use this position as long as it lasts. It will be over at some point, no doubt about it, and then we’ll focus on profits. But we want to make sure that until that moment happens, we go full speed. In this situation we felt that removing the margin target would be the right course of action. It is still the target we like, we just can’t commit to achieving it in a specific time frame, given the situation we have. And it felt even more right to do it at this point because of the upcoming change in revenue recognition.

Q: You have great success with The Secret Society, is this helpful attracting more third part developers?

VS: G5 always had great reputation among developers. At some point we worked with over 80 developers while focusing on unlockable games. We paid and continue paying substantial royalties to our partners. We are receiving numerous proposals from developers, every day. We are also committed to our long-time partners, very talented studios that we continue working with. The quality bar is pushed up constantly, and in the F2P business there’s much more focus on quality and experience, rather than quantity. Our team has developed very good understanding of how F2P games work and how to achieve success in this area. We can help studios achieve success in F2P games, like we did with TSS and other games. This brings developers to us.

Q: Can you comment on your fixed costs, and how much you can grow with the current organizational size?

VS: At this point there’s not much connection at all between our fixed costs and how big the sales of our games can grow. I think we could double, triple or quadruple the revenue with about the same number of employees. There is a certain standard of how much content and how many updates a game needs, but it’s based on the game play experience of a player within the game. It does not matter if a game has 10k daily users or 1M daily users, one player still needs the same amount of content to be happy. The pressure to increase fixed costs in development comes from the number of games in development/support, and from gradually increasing production values. Right now we have enough staff to take care of the games we have released and in development, and the pressure to increase budgets has slowed down after the transition to F2P was accomplished. The situation is similar in the marketing and other functions, where fixed costs need to scale proportionally to the number of games actively managed, but not the audience or the sales levels of particular games. Marketing 10k DAU game and 1M DAU game would not use substantially different amount of resources, at least in my experience. And if the games are of high quality, even player support function does not need to be scaled proportionally to the game audience

Q: Once the aggressive investment/growth phase ends, what are the profit margins one can expect from G5?

VS: This is going to depend on a number of factors, and the biggest ones would be how big G5 gets by then, how our portfolio composition is going to look like by then, and how good the games in the portfolio are going to be by then. The overall size is important to offset the fixed costs. The bigger we are going to be, the higher our gross margins would be. The more successful 1st party (G5’s own) games are going to be in our portfolio, the higher possible profit margins are going to be, as on these games we do not need to share revenue with other companies. And the better the games would be fundamentally, the less UA expenses we would need to incur to maintain and grow the sales. One could build a model which takes the assumption of certain revenue share (0% in case of 1st party games), certain UA expense level in proportion to the game revenue, certain composition of the portfolio, and certain fixed expenses, and calculates the profit margin that is possible given certain annual revenue. We actually do have such model internally. It shows a range of possible outcomes depending on the assumptions, it allows for very positive yet realistic scenarios, and we are navigating the company to the scenario which will provide good returns to the shareholders.

 

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