G5 Entertainment

Balanced profitability for G5 Entertainment going forward

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G5 Entertainment (G5EN:ST) reported their third quarter results last week. Revenues were up 51 percent year-on-year and reached SEK 96 million. Reported EBIT was SEK 4.7 million, but if adjusting for extraordinaty items (write-downs) the underlying EBIT was SEK 9.2 million. Going forward the company will continue to focus on a balanced approach regarding profitability and marketing. The share remain as one of our Alpha Picks. To download our updated one-pager on G5, click here to download it in PDF-format.

A first step in the direction of the company’s new strategy

Except for an improved and nice looking new reporting format G5 Entertainment’s report for the third quarter showed revenues of SEK 96.1 million, which was in line with their previous guidance and also slightly above our earlier expectations. Adjusted for extraordinary items, consisting of write-downs, G5’s Q3 EBIT margin came in at 9.6 percent. We argue that it is not an extraordinary well margin, but a large step towards increased profitability and also a clear indication that their new strategy of focused marketing is successful. In Q3 the company spent SEK 15.1 million on user acquisitions, compared to SEK 22.0 million in Q2. Their strongest growth continues to originate from their wholly-owned games named Mahjong Journey and Farm Clan.

The company also reported a few key performance indicators for the first time in its history. According to these G5 Entertainment has 2.7 million monthly active users (MAU) and 105,200 monthly unique paying users (MUP), implying a conversion ratio of 3.9 percent. Their monthly average gross revenue per paying user (MAGRPPU) was USD 30.3. Compared to King’s MAGRPPU of USD 24.5 and conversion ratio of 1.4 percent we argue that G5’s KPIs are very satisfactory.

Earlier we mentioned that a single-digit margin in the range of 6-9 percent would not cause us to raise our eyebrows. Following the report we are however satisfied even though the adjusted EBIT margin of 9.6 percent was just slightly above this range. The reason for our satisfaction is that the CEO, Vlad Suglobov, commented that Q3 was just a first step of the company’s new strategy. G5 will thus continue to focus on a balanced profitability going forward, and the one that was shown in this quarter did not emphasize its full potential. The third quarter is for example normally extra heavy on depreciations (SEK 8.5 million in Q3 compared to SEK 6.1 million i Q2) and thus dampened the profitability somewhat. The same pattern can be observed in the third quarter last year (SEK 6.0 million in Q3 vs SEK 4.5 million in Q2).

Given the third quarter’s results and also according to publicly available data from the first month of Q4 it is proven that G5 except for user acquisitions also acquires many users organically. In the chart to the right we display the continual improvement of G5’s games on US Ipad grossing (monetization) lists since the end of the second quarter, despite less user acquisitions. In the left chart we display G5’s revenues, their share of paid royalties and also their decreased focus on user acquisitions. We will later on discuss the reason why we expect increasing user acquisitions in Q4.

(Click on the charts to see them in full-size)

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Occasional write-downs are tedious but completely normal

The write-downs of SEK 4.5 million that were taken in the quarter was a result of less successful games. Alpha Researcher believes that the write-downs might include G5 Casino that was released in October last year, but it is yet only a speculation. In our view investors should expect occasional write-downs going forward. G5 is clear about them trying to build a portfolio of many games, rather than just focus on one-hit-wonders. Some of their new games might therefore be in new genres, like G5 Casino was, and thus run a higher risk of failure. But we are confident that the company will keep its main focus on games within hidden objects-, puzzle-, and time management genres. We will however not estimate any write-downs until we notice games that have very bad performance.

Currently there are ongoing work to provide players with holiday content during the fourth quarter. New games are also in pipeline and in the final stages of development. G5 Entertainment wants them to be released before the year-end. Releasing games in Q4 is a smart move since there are alot of holidays, such as Thanksgiving and Christmas holiday, in the United States.

As we mentioned earlier G5 also reported some key performance indicators (KPIs) for the first time in the company’s history. These indicators suggest that G5 continously is increasing their userbase and also their amount of monthly unique payers. As the chart below shows the fourth quarter last year posted a strong MAGRPPU of USD 36.1. We believe that the company will show an increasing MAGRPPU this year as well, thanks to the holidays in the quarter. The MUP-hike from Q4 2014 to Q1 2015 is also an interesting observation, and most likely a result of G5 releasing Mahjong Journey at the end of Q4 combined with a strong growth in TSS.

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In this year’s fourth quarter we expect that at least two new games will be released. That is also the reason why we expect somewhat increasing user acquisitions costs in the quarter, like we previously wrote and showed in a chart above. If one, or both, of the new games gain traction like Mahjong Journey did one year ago we expect the increased UA level to continue through Q1 2016. By looking at the revenue journey of Mahjong Journey (currently generating around SEK 15 million per quarter) we argue that an temporarily increased UA level should be seen as something positive despite dampened profitability in the relevant quarters. If this scenario happens Alpha Researcher believes that Q2 and Q3 next year may post significant earnings.

G5’s F2P games have a long life-time and revenue tail

Investors might wonder for how long G5’s blockbuster game, The Secret Society, will generate the current level of revenues to the company. The game was released three years ago and has since then generated an increasing amount of revenues year after year. At the beginning of 2015 the game experienced slightly falling grossing list placements (grossing placements on Ipad in the United States are shown in the chart below). We believe that the decline was due to the previously communicated issues with G5’s third-party developers. The decline could also have been due to temporarily re-allocated user acquisition spending on Mahjong Journey and some other titles. TSS’ downtrend was however abrupted during the summer, despite overall decreased user acquisition spending. If looking at a trailing 14-day basis the game has even gained 20 placements on Ipad in the United States since September. This improvement will lead to significantly higher revenues if the current placement lasts until the quarter-end.

G5Alpha Researcher’s investment case in G5 Entertainment is currently based on the assumption that Mahjong Journey and Farm Clan will retain, and perhaps also gain, placements during at least a few years forward. Mahjong Journey in particular is expected to continue to climb. The Secret Society is also expected to retain its placement during at least one or two years forward. The revenue tail of G5’s free-to-play games (F2P) has been proven to be unarguably long. We argue that those who oppose this should take another look at the market data that is available.

If these long tails are combined with another, one or two, successful in-house developed games like Mahjong Journey the company is likely to continue grow in a high pace and also improve its gross margin and overall profitability going forward. Along with G5’s new strategy of balancing user acquisitions and profitability we believe that their earnings will take-off in upcoming years.

Estimates

Given G5’s game performance since the end of Q3 it looks like revenues in Q4 could reach SEK 107 million in Q4. This is however just an early estimation generated though our model. With increased user acquisition costs at the end of the quarter we expect the company to post an EBIT result around SEK 8.5 million. In another scenario, where the current level of user acquisitions remain during the whole quarter, G5’s EBIT result is expected to be higher.

Given our base-case scenario of increasing UA costs in Q4 G5’s full-year 2015 revenues are expected to be SEK 390 million and the adjusted EBIT result is expected to reach SEK 26.3 million. According to these assumptions the adjusted EBIT margin will be 6.7 percent, an increase from 5.3 percent in 2014. The adjusted earnings per share will land at SEK 2.0. Furthermore, as the table below shows we expect the gross margin to increase from 44.7 to 47.4 percent, mainly due to an improved revenue mix from in-house developed games.

For full-year 2016 the mobile games market itself is expected to grow 15-20 percent. In  such an environment Alpha Researcher estimates that G5 will grow their top-line by 33 percent, implying revenues of SEK 519 million. Along with one successful game release the company’s gross margin is expected to slightly improve and thus increase to 49.0 percent. If G5 follows their new strategy and continues to balance marketing spending and profitability the EBIT should be able to reach SEK 54 million next year, resulting in an EBIT margin of 10.4 percent and an earnings per share of SEK 4.27.

According to these estimates G5’s share currently trades at a P/E ratio of 8.4 and an EV/EBIT multiple of 5.3 on next year’s earnings. We argue that this is a very attractive valuation given how flaming hot the world-wide gaming industry currently is. Our estimates also give room for a small write-down during next year, and to somewhat higher marketing costs than we expect. The share will remain as attractively valued in spite of these scenarios and is thus still included as one of our Alpha Picks.

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Disclosure and disclaimer

G5 Entertainment is a part of Alpha Researcher’s portfolio and is also included as one of our Alpha Picks. The analyst owns shares in the company. Click on the link to read our initation of coverage analysis of G5 Entertainment.

Alpha Researcher does not take any responsibility for investments made in G5 Entertainment. The analysis or article written above and all the conclusions that are made within it are solely Alpha Researcher’s opinions and expectations. It should absolutely not be seen as any investment advice. We highly encourage investors to make their own analysis and/or contacting investment professionals before buying any shares in G5 Entertainment.

Alpha Researcher will not be responsible for any errors or omissions in this analysis or article. Remember that no one but yourself is responsible for your own investments.

Alpha Researcher has not received any form of compensation for writing this material. The material is written to strictly highlight our independent view on the company/companies and its/their future prospects.

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