RealNetworks, Inc.
Q1 2018 Earnings Call Transcript

Published: 7 May 2018

[Operator:]

Good afternoon and welcome to the RealNetworks, Inc. First Quarter 2018 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Laura Bainbridge with Investor Relations. Please go ahead, Laura.

[Laura Bainbridge:]

Thank you and welcome to the RealNetworks first quarter 2018 financial results conference call. Before we begin, I will 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 its 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 fact are forward-looking and involve a number of risks and uncertainties that could cause actual results to differ materially from those 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 website. Forward-looking statements made today reflect RealNetworks’ expectations as of today, May 3, 2018. 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 a 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 website at investor.realnetworks.com under the tab Financial Information. With me today are Rob Glaser, Chairman and CEO and Cary Baker, CFO. Rob will discuss the company’s strategy and the progress the company has made in recent months. Cary will then provide a financial review of the first quarter of 2018 and the outlook for the second quarter of 2018. After today’s prepared remarks, Rob and Cary will be pleased to answer your questions. With that, I will hand the call over to Rob.

[Rob Glaser:]

Thanks, Laura and good afternoon everyone. Today, I want to discuss two main topics. First, Real’s results in Q1 put in the context of our focus on reinventing the company for the future and second, our progress on our four key growth initiatives. After that, I will provide a brief update on Napster, in which we own a large minority stake. Starting with our Q1 performance, revenues were $19.7 million, which was up from last quarter and flat with Q1 in 2017. Adjusted EBITDA was negative $3 million, which was better than both last quarter and Q1 of 2017. While we are little disappointed with these results, the cause was two factors that we understand and that are not related to our growth initiatives. One is the timing of shipments from an IP licensing partner. We expect to achieve the full value of the contract, but in later quarters than we originally forecasted. Second, relates to our GameHouse business, specifically our mobile games revenue. We are beginning to transition that business from a model based purely on sales of premium individual games to a combination of premium individual titles, advertising and subscription revenue. I will discuss our focus on subscriptions when I talk about our growth initiatives in a few minutes. One positive aspect of Q1 that I want to highlight is our transformation in our margin structure. At the end of 2017, we made the strategic decision to exit our low-margin Korea Music on Demand business. That effort, combined with other efforts in managing our cost resulted us increasing our gross margin to 43%, when including the MOD business a year ago to 74% in Q1 of ‘18. This enhanced margin structure sets us up to deliver more meaningful leverage as our growth initiatives begin to contribute revenue later this year. The final point I will make about Q1 is that we still believe we are in a path to grow revenue in 2018 and to achieve EBITDA profitability during the year. Now on to my second topic, our progress with our key growth initiatives, we have four major growth initiatives, three of which are B2B, RMHD, Kontxt and RealCV. And one of which is consumer-oriented, our mobile game subscription product called GameHouse Original Stories. Let me start with the B2B products. We continue to advance our RealMedia HD video technology or RMHD for short, focus on the China market. Our partner, CIBN, had soft launched RMHD as part of its mobile offering called Stars China, with the TV phase of the project scheduled to follow in the weeks ahead. As part of this initial launch CIBN will release thousands of hours and titles using RMHD as the only way to watch high-definition versions of the content. This will help seed the RMHD format ecosystem and drive longer term adoption of our RMHD codec in China. As we discussed before, our codec launch is a multifaceted process that involves developing the technology, deploying it through both our own products and partner products and advanced licensed third-parties to start to deploy content in the codec’s format. Our next-generation RMHD codec delivers high-quality video more efficiently than competing standards, especially at HD and above bit rates. While it takes time to successfully build a codec ecosystem, we are confident that we are in a good path to do so in China. We are in active discussions with several content providers, carriers and OEMs for the distribution of RMHD. We partnered with our first chipset manufacturer, Amlogic, in January for the pruning and optimization of RMHD in Amlogic chips technologies, which are widely used in China’s leading brands, smart TVs and streaming media devices. While our initial focus is on China, we are also laying the groundwork for other markets, primarily for our PC RealPlayer product, which is available worldwide. Just during 2017, consumers have used our RealPlayer to convert over 12 million files into the RMHD format. Next, I will discuss our progress with Kontxt, our next-generation mobile messaging platform. Kontxt allows carriers and network aggregators to intelligently manage messages across the network, which I expect will be increasingly important given the anticipated rise in commercial messaging. Kontxt builds upon our deep legacy in the messaging space across our platform we process over 1.5 billion messages daily on behalf of 300 mobile carriers and network aggregators worldwide. Kontxt enables carriers and network aggregators to block spam, to identify, classify and put policy around messages traveling across the networks and to eliminate, reroute traffic. Kontxt adds value to network operators, to aggregators and to marketers while also developing a better end-user experience. Interest among network aggregators and other partners is high. We will be in the market to announce our exclusive partnership with Syniverse beginning later this year. We are also improving concept testing with several prospective partners. Testing requires significant commitment from prospective partners. We tailor the trough, specifically the parameters identified by each partner and demonstrates the features of our platform by inspecting, analyzing and classifying messages that are meaningful to the partner’s business. While we are seeing high interest from a number of excellent partners, it’s also fair to say that the trough in the deployment cycle has proven longer than we had initially anticipated. Our third growth initiative is our computer vision platform, RealCV. RealCV is our next-generation facial recognition technology. This is the most nascent of our four growth initiatives and we feel it’s a very promising area. We expect to have much more to say in the months ahead. Finally, I got to talk about our consumer growth initiative, our GameHouse Original Stories subscription product. I would describe our mobile games initiatives having two phases. The first phase was for us to create a library of compelling games. This was our focus over the past few years as we scaled up from a four-game launched in 2015 to 10 launches in 2017, giving us a library of now over 30 games at the end of this quarter. We now entered the second phase by launching a full subscription product, again to Spotify and Netflix for a unique genre of story-based casual games. Over the past few weeks, we completed the global rollout of our subscription product on the Android platform. In the months ahead, we will be adding an iOS-based subscription product. While it’s early, the results are encouraging and we believe our subscription product will contribute to meaningful growth in our games business in the future. At the heart of our strategy is the ability to create excellent titles that combine fun gameplay with compelling stories. In support of this strategy, we’re pleased to announce the acquisition of Blue Giraffe is an independent studio which we’ve worked closely for a long time, including on some of the early Delicious titles and our most recent high-performing series, Heart’s Medicine. Going forward, Blue Giraffe will exclusively develop GameHouse original titles on behalf of GameHouse RealNetworks. Before I turn the call over to Cary, I will add a quick note on Napster. We are pleased with the results we’ve achieved due to changes implemented over the last year, including appointing Bill Patrizio as Chief Executive Officer and refocusing the business – company on business-to-business opportunities. Indeed, the first quarter 2018 marks Napster’s third consecutive quarter of positive operating income. We’re pleased to see the successful IPO by Spotify, which we think will help establish the value of businesses such as Napster in the marketplace. And with that, let me hand the call over to Cary.

[Cary Baker:]

Thanks, Rob and good afternoon everyone. In my remarks today, I will first review our consolidated first quarter results followed by a more detailed discussion of our segment business performance. I will then review our expectations for the second quarter of 2018. Before diving into the results, please note that year-over-year and sequential comparisons are not always apples-to-apples due to the periodic variability in our revenues and the adoption of the new revenue accounting standard in the first quarter of 2018. Certain of our businesses, including the IP licensing part of our Consumer Media business and the mobile games component of our games business, can fluctuate quarter-to-quarter, but we will continue to update you on these timing impacts and their implications. Turning to our results from continuing operations, for the first quarter, revenue was $19.7 million, flat with the prior year period and up from $18.9 million in the prior quarter. We are disappointed that revenue for the quarter did not meet our expectations. The slight shortfall was primarily attributable to our Consumer Media segment, and in particular, our IP revenue. Looking at these results in greater detail, revenue within the Consumer Media segment was down $200,000 year-over-year and $300,000 sequentially. The shortfall relative to our expectations was related to the timing of devices shift for an IP license partner. It’s worth reiterating that we expect to achieve the full annual value of this contract, but in later quarters than we originally forecasted. Mobile Services revenue was up $500,000 year-over-year and up $1.5 million sequentially as we continue to monetize our legacy products. In the first quarter, there were two specific examples where we did just that the first is a RealTimes contract amendment and extension with a major U.S. carrier and the second was an incremental ring-back tones contract with another major U.S. carrier. Finally, Games revenue for the first quarter was down $400,000 year-over-year and $500,000 sequentially due to the number and timing of game launches during the quarter. During the first quarter, we launched two new GameHouse Original Stories titles, one of which launched in the final week of the quarter. This compares to two launches in the prior year period, which were launched earlier in the quarter comparatively and three launches in the prior quarter. Gross profit was $14.5 million in the quarter, up $1.4 million over the prior year period and up $600,000 from the prior quarter. Gross margin from continuing operations for the first quarter was 74%, up from 67% in the prior year period and flat with the prior quarter. The year-over-year increase in gross margin is reflective of ongoing efficiencies in our consolidated cost of revenue line items, included improved bandwidth and customer support costs. Operating expenses in the quarter were $19.5 million, down 9% from the prior year period, reflecting our focus on maintaining a properly aligned cost structure, including reduced headcount and facilities expense. It’s also worth noting that operating expenses in the prior year quarter benefited from certain one-time credits, which mute the year-over-year improvement. On a sequential basis, operating expenses were up 4%, primarily reflecting sales and marketing expenses surrounding worldwide trade shows. Adjusted EBITDA for the quarter was a loss of $3 million compared to a loss of $4.6 million in the prior year period and a loss of $3.6 million in the prior quarter. Net loss was $5.2 million or $0.14 per share compared to a loss of $9.6 million or $0.26 per share in the prior year period and net income of $400,000 or $0.01 per share in the prior quarter. In the prior quarter, net income included a one-time $4.5 million gain on the final receipt of cash from the 2015 sale of our Slingo and social casino business. Turning to our first quarter segment results in more detail, Consumer Media segment contribution margin was a gain of $600,000 compared to a gain of $400,000 in the prior year period and a gain of $1.3 million in the prior quarter. The year-over-year improvement was largely driven by gross margin efficiencies. Compared to the prior quarter, contribution margin was impacted by lower revenue and higher operating expenses related to professional services and marketing. Mobile Services segment contribution was a loss of $700,000 compared to a loss of $2.7 million in the prior year period and a loss of $1.6 million in the prior quarter. The year-over-year and sequential improvements were primarily driven by increased revenue from the contracts with two existing carrier partners that were executed in the first quarter. Also, the sequential improvement was driven by the improved gross margin related to reduced bandwidth and personnel costs. Game segment contribution margin was a loss of $1.1 million compared to a loss of $900,000 in the prior year period and a loss of $1 million in the prior quarter. The slight year-over-year and sequential declines were mainly driven by lower revenue related to the timing and number of launches. On a sequential basis, the lower revenue was partially offset by $400,000 of lower operating expenses. At the corporate level, unallocated corporate expenses of $3.3 million decreased by $1 million compared to the prior year period and increased by $200,000 compared to the prior quarter. The year-over-year variance was mainly driven by lower restructuring costs of $1.1 million. Sequentially, expenses increased due to the timing of stock-based compensation expense, partially offset by lower G&A expenses. Now turning to our balance sheet, we ended the quarter with $54 million in unrestricted cash, cash equivalents and short-term investments, reflecting a sequential decline of $5.6 million, driven primarily by the net loss. Subsequent to the quarter-end, we completed the acquisition of Blue Giraffe for net cash consideration of EUR 3.6 million. I’ll now turn to our outlook. We are encouraged by the progress we have recently experienced in the trial and deployment of our key technologies. We are on track to deliver top line growth in 2018, the evidence of which will begin to manifest in the second half of the year. This expectation is influenced by our go-to-market plans for our growth initiatives. We are continuing to leverage our cost structure and expect to return to positive adjusted EBITDA during 2018. With that as a backdrop, for the second quarter, we currently expect total revenue in the range of $16 million to $18 million. We expect Q2 to mark the low point of revenue for the year and to show growth in the second half of the year. Adjusted EBITDA loss is expected to be in the range of minus $3.5 million to minus $5.5 million. We expect meaningful improvement in adjusted EBITDA in the back half of the year as our growth initiatives begin to contribute revenue and we leverage this growth on our improved cost structure. With that, we will now open the call for questions. Operator?

[Operator:]

Thank you. [Operator Instructions] We have a question from Mr. Dan Weston, WestCap Management. Please go ahead, sir.

[Dan Weston:]

Yes, hi. Good afternoon, guys. Thanks for taking the questions. You are going a little fast in the prepared remarks, I wanted to make sure I got my notes right. Cary, could you talk a little bit about what you are mentioning – the new renewal contracts relating to RealTimes and the ring-back tone business, could you explain that a little more clearly, please?

[Cary Baker:]

Yes, in the first quarter, Mobile Services revenue popped up versus the year ago period and sequentially and this was due to a couple of deals we landed on our legacy products. RealTimes, the first one was RealTimes with a large U.S. carrier this is an existing contract that we are able to amend and extend and as a result, got incremental revenue out of it in the quarter. And then the second one was an incremental ringback tones contract that we landed with another U.S. carrier.

[Dan Weston:]

So, would you expect the benefit from those two renewals to have occurred in Q1 and will not necessarily see that type of quarter-over-quarter growth? Was it a one-time event or how do we look at it going forward?

[Cary Baker:]

Yes, it is. It is more one-time in nature, but they do provide revenue ongoing.

[Rob Glaser:]

And the other thing I would add is that obviously we don’t guide on particular deals. The growth that we are focusing on is primarily tied to the four initiatives that I talked about. So, we might have some other legacy businesses that have a bump up here or there. And obviously, we are going to try to maximize both the value and the operating profit from those deals, but we think the four things we have identified will be the primary growth drivers for our company in the quarters ahead.

[Dan Weston:]

Got it. No, I appreciate that, Rob. Another question relating to the IP customer you talked about which had some timing issues relating to shipments in some of their products. Is there any color you can give us there in terms of what type of products they are and when do you expect to receive the revenues over the year?

[Rob Glaser:]

Well, we are usually pretty careful about not identifying customers by name. So, if we start going down that path, we could end up sort of doing that and get quack-like-a-duck conversation pretty quickly. The headline is the following. We have a few different kinds of contracts and partners. Some contracts where they pay us a variable amount based on how much they ship and some contracts, while we have a pretty clear sense of what the value of the contract is going to be worth, either because there is a hard commitment to it or we know their historical pattern of what they ship and there is some maximum as part of the agreement if they fully realize the contract that they will ship. So when we say we are confident, we are going to get the value of the contract, whether it’s one of those kinds of customers or the other, it certainly is the case that we have had a long track record with this customer and we know what they are likely going to deliver over time, but they do report on a quarterly basis and there might be variations in their shipment cycles of various products that use our technology that account for a different volume in a given quarter versus the previous quarter or we might have forecasted at the beginning the year, but it’s a very stable relationship is really the headline you should take away from that.

[Dan Weston:]

Okay. And then I appreciate that. The acquisition that you guys mentioned on Blue Giraffe, is there any other color you can give us in terms of more about what they do, how it fits into your business and any financials that you can possibly give to the Street?

[Rob Glaser:]

I will leave it to Cary whether he wants – whether there is anything to say about the financials. I will tell you sort of the history of it. So, Blue Giraffe is a studio, that’s made up of people primarily who were former GameHouse team members. And as you may remember, Rutger Peters and Erik Goossens, the two guys that are running GameHouse came back to run it about, I guess, at this time, about 3 – a little over 3 years ago. Prior to them coming back, these guys who had been colleagues of theirs were moved into a relationship with us, where they were an independent studio. They were developing titles primarily, but not exclusively for us. So we had a very friendly relationship, when they decided to kind of go off on their own. Subsequently because they are very close to the guys that are running the studio, they are running the whole business, Rutger and Erik. Rutger and Erik initiated conversations with them with our support, effectively about them coming back to the family. And we talked about it various times and the stars aligned for us to do that. So not everybody that’s joining is rejoining GameHouse, but I’d say the majority of the people have been part of this Blue Giraffe studio for a while and some of them go back to before these guys became sort of the friendly independent. So, it’s one of these situations that it has some structural impact, because they go from being a highly aligned studio to being a dedicated studio. That’s a plus. There are opportunities to leverage them across more of our assets than just the individual games that they work on. And that’s exciting. And they are really a talented team. So we are very happy to have them completely in the fold, but it’s not a – it’s not like some cumbersome group that we never worked with. There is a long established relationship. It’s a trust relationship and the sort of the reintegration is something that we think will be very smooth. I don’t know, Cary, if you want to add anything to that.

[Cary Baker:]

No. I think that from a net cash consideration, it was €3.6 million. We will have more about that in the financial impact in our second quarter Q since this was a subsequent event. From a P&L perspective, this is acquiring a team that is critical to our mobile subscriptions and our gaming strategy and we expect the closer involvement and closer integration of this team to be reflected in our ability to achieve success with that growth initiative.

[Dan Weston:]

Okay, fair enough. I will jump back out in case anyone else wants to ask a question. Thank you, guys.

[Rob Glaser:]

Operator, I think we are ready for the next question.

[Operator:]

Very good. The next question is from [indiscernible] Crown Capital. Please go ahead, sir.

[Unidentified Analyst:]

Hi, guys. Thanks for taking the call. I had a question around the difference in the pricing structure for the gaming license that contributed to the revenue dip. So you are switching to subscription pricing scheme, was it a forklift price change, like what was the cause for the decrease in the quarter?

[Rob Glaser:]

Well, we don’t go into sort of the innards of each segments all of the variations, but I would say the following we obviously reported out the number – the revenue number of the segment. We are going to transition this business from selling individual games for $10, which was the primary way our mobile business worked for as we started scaling it up. And as I mentioned, our attention for some time has been once we got a library of titles that we thought were sufficient to move to a subscription value proposition. At the same time for a few different reasons, we have also introduced an advertising revenue stream. So, when you look at all these factors, a few things move around. In the case of advertising, you get more money over a long time for product use rather than getting money the minute they switched from free to paid, because in the advertising firm of the product, you can keep playing the game without paying to buy that title. In the subscription version of the game, you actually are paying both to get full use of the title and to have no advertising in there and to get access to a whole other library of titles. We are testing various price points and various value propositions. We have tested immediate payment. We have tested a free trial period following that. We have tested a few different price points for the subscription and different price points, obviously of different short-term economic characteristics. We think – but we are early in the process, we only have a couple of months in, when we got out of like really narrow tests where we have enough geographies to have consistently meaningful results. We think the lifetime value of the subscribers is going to be significantly greater than the lifetime value of the individual purchasers. And so that means that over time, we think that will create an opportunity to grow the business significantly. And also if you have higher lifetime value customers, you can pay more to acquire them, so you can grow the business that way too, but in this early phase, there is a set of effects, including some substitution effects. And then there is also the fact that the team is focusing on multiple different pieces of monetization at the same time. So overall, the short-term perturbation to revenue, obviously, we would have loved to have the thing just go up into the right, but I have seen this picture before, when you introduced a new model, particularly you go from individual sales to subscriptions, I have seen that happen in the past where you see a short-term dip before the subscriptions hit scale.

[Unidentified Analyst:]

Got it. Thank you. That’s very helpful. I was curious so LoEn obviously was a big concentrated customer in the past, is there any customer concentration in the quarter?

[Cary Baker:]

No more than – LoEn was unique in terms of the size of revenue. I think in 2017, it attributed – it was $46 million in revenue on a revenue base of about $125 million pre-discontinued operations. There is no other concentration like that in our continuing operations.

[Rob Glaser:]

And as I pointed out in my comment too in the distant past, it was a nice profitable piece of business, but in the recent couple of years, it became almost a pass-through business. So as you see, the result of taking it out is that our gross margin went – shot way up from 43% to 74% now combined with some other things Cary mentioned. And the results of that obviously is the company that shaped more like we wanted to be shape going forward, where every new dollar we create, $3 out of $4 have the opportunity to drop to the bottom line depending on what the OpEx are.

[Unidentified Analyst:]

Sure, okay. Thank you. And just to clarify on the EBITDA, the return to adjusted EBITDA profitability that’s within a quarter within 2018 or for full year 2018?

[Cary Baker:]

It’s during 2018.

[Unidentified Analyst:]

Okay. Okay, great. I will jump back into queue.

[Cary Baker:]

Thank you.

[Operator:]

[Operator Instructions] Ladies and gentlemen, we have reached the end of the question-and-answer session. I would like to turn the call back over to Mr. Rob Glaser for closing remarks. Please go ahead, sir.

[Rob Glaser:]

Thanks, operator and thanks, everyone. As always, we want to thank you for participating in our call. We look forward to keeping you updated on our progress. And if not sooner, I look forward to talking to you all again in 3 months.

[Operator:]

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