RealNetworks, Inc.
Q3 2017 Earnings Call Transcript

Published: 2 Nov 2017

[Operator:]

Greetings, and welcome to the RealNetworks’ Third Quarter 2017 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Laura Bainbridge, Investor Relations. Thank you. You may begin.

[Laura Bainbridge:]

Thank you. Welcome to the RealNetworks’ third quarter 2017 financial results conference call. Before we begin, I remind you that some matters discussed today are forward-looking, including statements regarding RealNetworks’ future revenue, gross profit, adjusted EBITDA, and operating expenses and trends affecting it’s businesses and prospects for future growth and profitability. Other forward-looking statements include the Company’s plans to implement its strategy and invest in its products and initiatives, as well as the expected growth, profitability and other benefits from these activities. Statements that express our belief and expectations, and all statements other than statements of historical facts, are forward-looking and involve a number of risks and uncertainties that could cause actual results to differ materially from these forward-looking statements. We describe these and other risks in our SEC filings, including in the risk factors set forth in our most recent report on Form 10-K and in other reports. A copy of those filings can be obtained from the SEC or from the Investor Relations section of our corporate Web site. Forward-looking statements made today reflect RealNetworks’ expectations as of today, November 1, 2017. The Company undertakes no duty to update or revise any forward-looking statements made during this call, whether as a result of new information, future events or any other reason. In addition, we will present certain financial measures on this call that will be considered non-GAAP under the SEC’s Regulation G. For reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure, please refer to the information included in our press release and in our Form 8-K dated and submitted to the SEC today, both of which can be found on our corporate Web site at investor.realnetworks.com under the tab Financial Information. With me today are Rob Glaser, Chairman and CEO and Cary Baker, our CFO. Rob will discuss the Company’s strategy and the progress the Company has made in recent months. Then Cary will provide a financial review of the third quarter of 2017 and the outlook for the fourth quarter of 2017. After today's prepared remarks, Rob and Cary we will be pleased to answer questions. With that, I will hand the call over to Rob.

[Rob Glaser:]

Thanks, Laura. Good afternoon and thanks everyone for joining us. On today's call, I’ll recap our third quarter highlights, focusing on two primary areas; first, our financial performance and ongoing actions to promote financial stability; and second, our significant traction with our key growth initiatives. In particular, I’ll discuss two initiatives that are for long for us to see how and when they will lead to meaningful revenue. Then I will pass it on to Cary to go for the numbers in detail. Starting with financial performance. Overall, we were pleased with our results. Revenue was $330 million, modestly lower by 3% when compared to the prior year period. As we mentioned in Q2, due to the timing of customer shipments, our IP business receives revenue in the second quarter that we previously expected to receive in the third and fourth quarters. Adjusted EBITDA improved by $2.1 million versus the prior year period. We view this improvement as particularly notable in light of our ongoing investments in key growth initiatives. Our operating expenses were down 22% year-over-year. Within our respected businesses, we’re aligning and rightsizing in line with our growth prospects. The diversity of our portfolio helps us to concurrently two important objectives; creating financial stability, while also position the Company for top line growth. Our games business is a great example, real growth in mobile games continues to offset the decline in our legacy PC subscription business. Our mobile games business grew 12% in the third quarter as compared to a year ago, benefiting for ongoing investment in GameHouse app Original Stories. We released two new titles during the quarter, including the next title in our very popular Delicious franchise, Emily's Miracle of Life. Over the last 12 months, we've launched 10 new GameHouse Original Stories. This is by far our most prolific period. Our portfolio now includes over 25 GameHouse Original Stories, to which we have exclusive license. Indeed in most cases, we own the title of that right. Now that our portfolio is reaching critical mass, we expect to leverage it new ways in the months and quarters ahead. I’ll now move to my second topic, traction with key growth initiatives. Most noteworthy with our progress with our RealMedia HD or full name RealMedia HD RMHD technology and product. As you know, RMHD is a next generation codec but it's far superior to the current incumbent, H.264 and then also a significant advantages when compared to other next generation codecs, such as HCVC/H.265. Our most significant RMHD event in Q3 with the announcement of our strategic alliance with CIBN, one of the few largest OTT providers in China; OTT, or over the top, delivery of video over the Internet is one of the fastest growing parts of the Chinese Internet market. And CIBN is only one of the seven networks in the Chinese market that has license to distribute media over the Internet to televisions instead of through cable, broadcast or satellites. By leveraging our RMHD technology, CIBN’s users will enjoy faster, higher quality and more reliable streaming over the Internet with reduced data cost and storage of cost. We expect CIBN to encode thousands of titles and streaming hours into our RMHD format, which we expect will drive demand for our product technologies in China, among other content providers, carriers and OEMs. Either the case with our current IP business, revenue will come from licensing our codec technology to third parties, such as these, two enable their devices to play encoded content. We have much work to do to ensure successful rollout of our RMHD by CIBN. Once we've done so, we believe this will pave the way for significant adoption of our RMHD codec in China, and eventually worldwide. The second growth initiatives that’s progressing well is the new product from our messaging business. As we highlighted on our last call, at the beginning of Q3, we entered into a non-exclusive contract with Syniverse to bring this product to market. We expect to have more to say about our next generation messaging product suite before year-end, and think that we'll generate meaningful revenue from it in 2018. In summary, we're pleased to deliver progress in our new initiatives, while also investing in prudently in managing our costs carefully. This creates financial stability now where we're laying a foundation that we believe will drive the top line with profitable revenue in the years to come. Finally, we remain active in the evaluation of strategic alternatives for Rhapsody and are unable to provide further updates at this time. And with that, I'll hand the call over to Cary to discuss our third quarter financial results in more detail. Cary.

[Cary Baker:]

Thanks, Rob and good afternoon, everyone. In my remarks today, I will first review our consolidated results followed by a more detailed discussion of our segment business performance. I will then review our expectations for the fourth quarter of 2017. For the quarter, consolidated revenue of $30 million was down 3% from $31.1 million in the prior year period and down 9% from $33.1 million in the prior quarter. Mobile services revenue grew $1.4 million year-over-year, largely reflecting growth in our low margin Korean music on-demand business. On a sequential basis, the 100,000 decline reflects lower revenues from our inter-carrier messaging and Korean music on-demand businesses, partially offset by growth in our real times and ringback tones businesses. Consumer media rev was $2.3 million year-over-year, reflecting tiny variability in IT contact revenue from our codec technologies and ongoing declines in our legacy PC based product. And as anticipated, revenues were down sequentially, also reflecting timing of IP contract revenues. Finally, games revenue was down 200,000 year-over-year and down 300,000 sequentially. Compared to the prior year period and prior quarter, the decrease was a result of declines in our legacy PC subscription business, mostly offset by increases in mobile games. Operating expenses in the quarter were $17.7 million, down 22% from prior year period and down 4% from the prior quarter. In the third quarter, we undertook restructuring efforts that benefited segment margins and profitability. We believe our current cost structure is more in line with our sales and we will maintain our focus on reallocating and realigning our resources towards our key growth initiatives. Adjusted EBITDA for the third quarter was a loss of $2.3 million compared to a loss of $4.5 million in the third quarter last year, and a loss of $800,000 in the second quarter. Now, let's look at our third quarter 2017 results by segment in greater detail. Mobile services revenue was $19.1 million, up 8% for the prior year period and down 1% sequentially. Year-over-year, performance was largely driven by growth from our low margin music on-demand customer in Korea, Lowen Entertainment. As we noted in today's press release, this contract is set to expire at the end of the year and we do not anticipate renewal. The nature of our relationship with this customer has evolved over time, and we believe we have largely maximized its value. We've often referred to this revenue as low margin, because it is not representative of the gross margin profile for the rest of our portfolio. Over the course of our relationship, gross margin has declined from more meaningful levels to less than 3% currently. So while Lowen accounted for revenue of $11.4 million and $33.8 million in the three and nine months ended September 30, 2017 respectively, we do not consider the impact to gross profit as significant. To illustrate this point, for the same three and nine month periods, gross profit for this music on demand contract amounted to $250,000 and $900,000 respectively. As Rob previously noted, our strategy is to focus our resources on products that deliver higher margins and are scalable over time. We will continue to manage the business for efficiency, while investing in initiatives that we expect will contribute profitable revenue. Contribution margin in our mobile services segment for the third quarter was a loss of $400,000 compared to a loss of $2.8 million in the same period last year, and to a loss of $500,000 in the prior quarter. The year-over-year and sequential improvement was largely driven by restructuring measures. In our consumer media segment, which combines the RealPlayer products and the IP codec, including our new RMHD codec technology, revenue was $4.2 million in the quarter, reflecting a decline of 35% year-over-year and 40% sequentially. As mentioned previously, the timing of revenue from our IP codec business impacted the sequential compares. And when compared with the decline in our legacy PC product explains the year-over-year segment decline. Contribution margin in this segment was a gain of $40,000 compared to a gain of $1 million in the same period last year, and a gain of $2.2 million in the prior quarter. As expected, contribution margin for the quarter was impacted as we did not experience the higher gross margin IP codec licensing revenue benefit we received in the prior quarter. In our Games segment, revenue was $6.7 million, down 3% from the third quarter of 2016 and down 4% from the prior quarter as growth in mobile games was offset by continued decline in our legacy PC subscription business. Mobile games grew about 12% over the prior year quarter led by the release of two new games. We have now launched seven new titles in 2017. Sequentially, revenue was impacted by one fewer launch in the third quarter as compared to the second quarter. Third quarter contribution margin in the games segment was a loss of $400,000 compared to a gain of $200,000 in the same period last year, and a loss of $700,000 in the prior quarter. On a year-over-year basis, this decline reflects our continued investment in our mobile games business, which should allow us to increase the future productions of GameHouse Original titles. Sequentially, contribution margins benefitted from a product mix shift within our Mobile Games segment. Turning back to the corporate level. Unallocated corporate expense of $2.9 million declined by 48% for the prior year period, this was driven by a reduction in headcount and facilities expense, as well as lower restructuring cost. Sequentially, unallocated corporate expense was relatively flat, reflecting our focus on maintaining the right level of operating expense to support our growth. We had $59.1 million in unrestricted cash, cash equivalents and short term investments at the end of the third quarter. During the quarter, our cash consumption was impacted by our EBITDA loss of $2.3 million. I'll now turn to our outlook for the fourth quarter. As noted, year-over-year and sequential comparisons are not always apples-to-apples due to the periodic variability in our revenues. Nevertheless, we are pleased with our adaptability to these variable quarters, evidenced by our ability to maintain operational efficiencies and financial stability. We believe our strategic initiatives to drive the top line with profitable growth remain on track, and our disciplined approach to operating expense is evident in the results. With that as a backdrop, for the fourth quarter, we currently expect total revenue in the range of $29 million to $31 million and an adjusted EBITDA loss expected to be in the range of minus $2 million from minus $4 million. Please note that our guidance for the fourth quarter includes the contribution from our music on demand customer in Korea. With that, we will now open the call for questions. Operator?

[Operator:]

Thank you. At this time, we'll be conducting a question-and-answer session [Operator Instructions]. Our first question comes from William Meyers with Miller Asset Management. Please proceed with your question.

[William Meyers:]

Your Korea statement, if I understood that correctly, you're going to end the Korea agreement at the end of this year, and that’s going to main a major drop in revenue, beginning in Q1 but not a drop in profits. Is that correct?

[Rob Glaser:]

Almost exactly correct. We have not consummated a process to either formally end or for that matter renew, is the customers that we obviously have a long history with. We thinks it's highly likely on present course on street that we won’t have a renewal of a contract that makes economic sense for us, I guess, I would say for both parties, but I care about us. So it's in that context that we’re likely to not proceed and rather than have any of the recent price by that given the specific profile of the business, we wanted to mention it. If you look at the business, historically, it used to be a source and it used to mean going back four, five, six years, of reasonable amount of gross profit. It's become, for a variety of reasons, essentially a breakeven business before we got to our cost or slightly profitability before we get to our cost. And obviously, below the gross profit line for any piece of business we run, we have cost associated with the two. So when we looked at our portfolio of businesses and where we wanted to invest our future effort, we have made a series of investments, a few of which I talked about, games, messaging and RMHD video technology where we see opportunity for significant growth and profit, both gross profit and net profit. So you have something that has very little gross profit in it. It tends to get into a lower priority and eventually can follow the top line. And given as you say, given that it has a notable amount of gross revenue associated with it, we wanted to lay that now so people wouldn’t be surprised if when we do forecast for Q1 of '18, they didn’t see that here in there.

[William Meyers:]

I appreciate you're doing that upfront and I have just one another question. Can you give us a little bit more of a timeline on the CIBN Oriental Network video codec deal. Is that something that they’re actually using now? Is that something -- and when might that become a material generator of revenue?

[Rob Glaser:]

Well, I have to be -- because it's a partner, I have to be careful of what I say about their usage. We're very actively engaged with them in the process of setting the system up for deployment. I don’t know that they have specified when they’re going to deploy the product. In terms of connecting with revenue, in 2018 which I think is the relevant time period since we’re almost at the end of 2017. Generally speaking, the way we make money from video technology is not by getting licensing fees from the broadcasters, but it's by getting fees from the devices that consume the content, play back the content. So essentially, the setting up next generation of this business involves getting people to create lots of content in the format. So what happens with there as you get the content created in the format and it drives demand for devices that support the playback of the content in that format. And that's generally how we set the business up for in the previous generation and that's basically the way it still works. So most of the economic benefits from this relationship, I guess, you could say will be indirect rather than direct. And without commenting further on the timeframe for that, we do think it's an important catalyst for the business.

[William Meyers:]

And one follow-up, just to make sure I understand. In terms of putting the media into the new codec, you don't have to create it in the codec. I presume that you can -- that it’s an algorithm and anything can be converted to the codec if someone wants to do that. Is that correct?

[Rob Glaser:]

That's right. Typically, I mean, there's two use case scenarios one that's more of a broadcaster scenario one that's a consumer scenario. The broadcaster scenario is where they start out in the highest format, the original broadcast format typically and then it would get transcoded down and coded into a format that is very high quality, but much more efficient. So in that case, you might be starting with like a full-on HD or even a 4K file and then you're transcoding it down. A second use case, which also we add value to but would be probably less relevant in CIBN but relevant to loss really use cases, it’s when there's content that's already in a compressing format, say like HVAC 264 and essentially our software allows the transcoding of that. So essentially, we convert it from that format to our format. And so when we do comparisons of file sizes, they are comparisons that work in both cases, where you have the original big file and you compare the size that it would be in RMHD versus the size that would be in HVAC 264, or then you have the transcoding case where it converts from HVAC 264 directly over, which is something that for instance a consumer might do if they had video files that they captured from their camcorder or phone or the like that were in 264 and they wanted to transfer those to RMHD. So it’s for both use cases, but the broadcasters usually start with the highest quality source material.

[William Meyers:]

Okay, thank you. I appreciate all that detail.

[Rob Glaser:]

Great. I'm going to make Cary answer the next question, so I don't give you long answers. Operator, ready for the next question.

[Operator:]

Our next question comes from Dan Weston with Westcap Management. Please proceed with your question.

[Dan Weston:]

Maybe we can just continue on that line of questioning on the CIBN, just so I get a sense. Can you give us some kind of an idea of how many subscribers CIBN Oriental has currently?

[Rob Glaser:]

I think the numbers that they’ve quoted publicly are that and their various affiliates have $250 million users in China. I think it's the latest number that I saw and Cary if that sounds wrong, please contradict me. But that sounds there are right now. To be clear, not all those users are -- they have a fewer product, they have free products, they have paid products. So I don’t think they have $250 million paid subscribers, so it’s all like the equivalent of Comcast number, it's a little bit more like the equivalent of NBC's number or something like that. But it’s tier to have some free products and some premium products. People consume their products on a range of devices, but because this is China, the scale of this stuff is pretty massive.

[Dan Weston:]

No, understood. And there's obviously part of the larger umbrella organization as well, which we can get to later. But on the codec initiatives, could you refresh our memories. Are you clearly in three different Huawei devices as we speak today?

[Rob Glaser:]

We maybe in more than that because they're constantly evolving their model, we're in a very high volume of Huawei devices on the mobile phones. And just to be clear, our technology is designed to be implemented either as pure software or with hardware implementations; on a mobile phone, on a PC, on a tablet, it could be implemented as software. Antenna like a set top box or embedded in a television, it would typically be the case that people would deploy it within a chip, and that has a few different implications; one, the timeframe of implementation because of software we have basically the minute the product is done, we have software implementation so we can deliver with partners where with whom we're talking about a chip implementation, there's a process to getting the chips made. There're not currently RMHD chips shipping, getting those chips to ship and get deployed is an important part of the CIBN partnership was always part of our strategic roadmap. But I think they will be an important catalyst for the chip implementation of them. Our previous codec RMVB is available both as software and as chips in the video decompression chips, so we’ve experimented both of those. But that's the nature of that business as you get people a choice. And generally speaking, more the device and appliance, like a television or set top box, the greater the interest in having the implementation be as a chip rather than software running on a CPU.

[Dan Weston:]

No, I appreciate the clarification there. So do you have any sense on when chips will start hitting the market with the RHMD codec?

[Rob Glaser:]

I don't think we're publicly commenting that, but we certainly think that's a very important priority and we're making good progress against that. And when we have -- when we have something to announce, we’re obviously going to announce it publicly. So we have not chosen to announce the date for that in events or at least so far in advance of the general availability.

[Dan Weston:]

And then lastly to close the loop on CIBN and the codec. When you made that announcement with CIBN, it seemed like you’ve got a lot of headway in China. And I'm wondering did that increase your overall sales activity vis-à-vis let's say competitors to Huawei that may have noticed it and maybe started discussions with you all?

[Rob Glaser:]

Our General Manager, Morris Zhang in China, is very happy with the momentum that came out of that announcement. I was there for that announcement. A couple of my colleagues from Seattle are going back to meet with Morrison and the team in a week or two. Morris will get here in a few weeks. So between those interactions, we'll get a more fulsome update. Yes, the impact on the pipeline activity has been positive. I'm guessing, frankly, we'll be even more positive once we're deployed. But obviously, the momentum is a positive thing and it builds on itself. So both the announcement is the source of momentum and then the commercial deployment, we think will also be a source of momentum.

[Dan Weston:]

Just a couple others, if I may. Cary, maybe you can give you -- I just wanted to get a little more clarity on the consumer media business and decline there. You obviously had a very stellar quarter in Q2 for reasons we've talked about. But the decline seems like it more than offset those one-time events that occurred in Q2. Was there any serious degradation in the legacy real media player that also contributed there, or may be give a little more color?

[Cary Baker:]

There was no degradation in the legacy products. What you saw is the timing variability that we have in our IP codec business. In Q2, we recognized a chunk of revenue that we thought we were going to get over Q2, Q3 and Q4. So that pulled all that revenue forward into Q2. And as we discussed last quarter and then we mentioned this quarter, those sequential comparisons are going to be difficult given the way the revenue is recognized on certain contracts.

[Dan Weston:]

Yes, because I mean if you look back over the last let's say trailing four quarters outside of Q2 that business is tracking at somewhere let's say between five, six and six, four per quarter, and then you posted this, almost $7 million in Q2 and then down to $4 million in Q3. So was the delta, I'm reading it right, that you're generating roughly $1.5 million of revenue that hit in Q2 from the codecs or licensing pull through, if you will, that didn’t continue in Q3?

[Cary Baker:]

Well, we haven't broken out the specifics of the contracts and we don’t intent to do so. What I would say is this. The IP continues to perform as expected. We have some lumpiness in the way in which revenues recognize and that’s creating some of those spikes and troughs that you see. Our legacy products that are also in our consumer media segment have continued to perform at recent historical rate. So the business is performing where we thought. It's just what you see is the manifestation of that lumpiness of revenue.

[Dan Weston:]

And then on the Korean business, you mentioned that it had a very minimal impact on your gross profit margin. Can you elaborate a little bit on what type of an impact it would have on your operating margin?

[Cary Baker:]

Well, we don’t break operating margin down at a product level and this is all rolled up into our mobile services segment. I think the most important metric to focus on is gross profit and the fact that it doesn’t have a meaningful or a meaningful impact on to our overall gross profit.

[Rob Glaser:]

But I think it's fairly to say when you look at what we've done to manage our costs. This is Rob. Anytime we have situation where we have an opportunity to gain more efficiency, we avail ourselves with that. So I think it's fair to say that in analyzing this opportunity in this situation and in conversations with the long time customer and partner, in its relationship that I think they’ve got a lot of value out of and we’ve got a lot of value out of, but sometimes things run their course. And if you look at sub 3% gross margin on the business that doesn’t fit the profile of the company. I mean, when we report, assuming that we don’t renew which is what we’ve signaled back to directions to go in and we start looking at '18, you’ll see gross margins for that sector and for the division -- for the division as a whole and for the company as a whole, shoot up significantly. And obviously gross margin is fuel that you can use to create profitability. The absolute amount of gross profit is not going to go up, it's going to do down a little bit. But the percentage of gross profit is going to be much, much higher. And then if we keep adding in businesses with higher gross profit, the rest take care of itself.

[Dan Weston:]

No, I appreciate that Rob. I guess, I asked it in a long winded way. I guess the short question would be, is it going to have a positive impact on your operating income for that division when you divested or leave it?

[Rob Glaser:]

It's going to have a minimal effect [multiple speakers]. And obviously when we scale the business up, in other ways, that has a positive effect. So there's direct and indirect and indirect includes opportunity cost and managing bandwidth.

[Dan Weston:]

No, fair enough and it's fair comment. And lastly, Cary, pursuant to your sale in the past of the social casino games, I think we're still expecting a $4 million cash payment. Do you expect that to occur in Q4?

[Cary Baker:]

Yes, we expect it to occur in Q4.

[Dan Weston:]

Very good, alright thank you very much guys, appreciate it.

[Cary Baker:]

Thanks Dan.

[Rob Glaser:]

Operator, are we set or do we have any last question.

[Operator:]

At this time, we have no further questions. I'll now turn it back to Rob Glaser, CEO for closing remarks.

[Rob Glaser:]

Well, thank you, operator. And thanks everyone for joining today's call. We appreciate your continued interest in RealNetworks. We look forward to keep you updated on our progress and talking to you in three months time, if not sooner. Take care everybody.

[Operator:]

This concludes today's conference. You may disconnect your lines, at this time. Thank you for your participation.