RealNetworks, Inc.
Q2 2018 Earnings Call Transcript

Published: 4 Aug 2018

[Operator:]

Greeting and welcome to the RealNetworks, Incorporated Second Quarter 2018 Earnings Conference Call. At this time, all participants are in 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 with Investor Relations.

[Laura Bainbridge:]

Thank you and welcome to the RealNetworks second 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 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 website. Forward-looking statements made today reflect RealNetworks’ expectations as of today, August 1, 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 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 Financial Information tab. 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 second quarter of 2018 and the outlook for the third quarter 2018. After today’s prepared remarks, Rob and Cary will be pleased to answer questions. With that, I will hand the call over to Rob.

[Robert Glaser:]

Thanks, Laura and good afternoon everyone. Today, I'll start by discussing the launch of our state-of-the-art facial recognition platform, SAFR. Next, I'll update you on progress with our other key growth initiatives, specifically RMHD, Kontxt and mobile games. Finally, I'll close with a discussion of our Q2 results in the context of these growth initiatives. First, let's start with the newest addition to the RealNetworks family of products, SAFR, Secure, Accurate Facial Recognition. We launched SAFR on July 17. Since it's only been out for two weeks, it's quite premature to talk about SAFR's commercial trajectory. Having said that, we couldn't be happier with how our announcement was received by potential customers and partners. We made two announcements on July 17, the SAFR platform itself and a specific version of the product SAFR for K-12 education. SAFR is a state-of-the-art facial recognition platform, uses an advance artificial intelligence approach called machine learning to deliver world-class results. SAFR is highly accurate, delivering 99.8% accuracy based on the industry standard LFW benchmark. What's more, in June, testing by the National Institute of Standards and Technology, NIST, ranked SAFR as the number one U.S. based facial recognition platform in several key categories, and is one of the world's top recognition algorithms, overall. While SAFR is a very advanced platform, it works with off-the-shelf hardware, such as IP-based cameras, industry-standard phones, tablets and personal computers to recognize people in Real time, in Real world conditions. In addition to announcing the SAFR platform, we announced a specific offering designed for the educational market called SAFR for K-12 schools. We will offer two versions of the K-12 product, a very robust free version that runs within a school on their local network and a premium version designed for school systems and more advanced school uses. School safety has become one of the top national issues in the United States, and we're proud to contribute to helping make schools safer. Having a version of SAFR, that we're making available for free to every K-12 school in the U.S. and Canada, is turning out to be a great way to raise awareness. Both of our great platform and of the value that facial recognition systems such as SAFR can bring to school safety. RealNetworks' has a great success during our nearly 25 year history, providing free versions of our products to build ecosystems and drive demand for premium offerings. We think SAFR can be the next successful example of this strategy. As you likely know, face recognition technology raises important issues of privacy and civil liberties. We've built SAFR to be responsible over these concerns, for instance in how we use encryption and where and how we empower customers to control their data. We also support industry initiatives to encourage the formation of robust public policies around facial recognition systems, such as the recent call by Microsoft President, Brad Smith for appropriate government regulation. As mentioned above, we're very excited about the launch of the SAFR platform and the SAFR for K-12 schools. We also intend to make SAFR available for additional markets, beginning this fall. Vertical markets, such as stadiums and other venues, commercial offices and real estate and healthcare are natural opportunities for SAFR. We look forward to providing you with updates on our progress with SAFR in the months ahead. My next topic is a brief update on our progress in each of our other three growth initiatives. I'll start with RMHD, RealMedia High Definition platform. A major highlight in Q2 was the commercial deployment of RMHD on CIBN's mobile platform starts in China in June. As you probably remember CIBN is one of the top three OTT video providers in China. A related highlight of the quarter took place in late June, when our CTO, Reza Rassool and I joined our team in Beijing to host a codec technology summit, securing senior level participation from throughout top leaders in CIBN and others in the Chinese video ecosystem. As you've heard us say before, building a codec ecosystem for RMHD will take time. The commercial release of RMHD by CIBN will help stimulate the creation of such a robust ecosystem of devices and platforms using our RMHD video codec. We are committed to working with content providers, chipset manufacturers and consumer electronics companies to make this happen. Next, I'll highlight our progress with Kontxt, our next-generation mobile messaging and text spam and classification platform. Market interest in Kontxt remains high. During the quarter, we advanced several proof-of-concept trials, in which we were able to provide an in-depth demonstration of the features and capabilities of our platform to commercial discussions with major carriers and aggregators. While the sales cycles are turning out to be longer than we initially anticipated, we're encouraged by the evolution of our partner discussions. The fourth and final growth initiative I want to touch on is our mobile games subscription offering, GameHouse Original Stories. During the quarter, we completed the global rollout of our subscription products on the Android platform, and we now have over 18 game titles available to our Android's subscribers at a monthly price of about $10 per month. In July, we began our rollout on iOS starting in the Netherlands, Mexico and the U.S. We expect to be deployed globally on iOS later this year. In addition to our distribution to mobile app stores, we're starting to leverage our network of carrier relationships to expand the reach of our mobile games subscriptions. We recently partnered with Vivo, the largest telecommunication company in Brazil to roll out an original game as subscription offering under Vivo's brand. While it's early days, we're excited by the initial uptake and the engagement Vivo's users are demonstrating. As you know, at the core of our strategy of mobile games is the creation of compelling content. Through our acquisition of Blue Giraffe, we were able to bring in house one of our most successful studios. With the integration of Blue Giraffe now complete, largely, we will leverage the track record of creating fun and engaging others to strengthen our library of game as original titles, and will make our subscription offering even more robust. We will also leverage their talented team to bring GameHouse into the promising segment of free-to-play or FTP games within app purchases. One of the most successful GameHouse Original Stories, which comes from Blue Giraffe is our Heart's Medicine. We are just now in the process of globally launching Heart's Medicine 4, which is our first free-to-play GameHouse Original Stories title. We're optimistic that HM4 will do well, but the nature of FTP games is that they monetize over a longer period of time than is typically the case with freemium titles. With the shift of this title to free to play, we delayed the global release until Q3, later than we originally anticipated, which had a negative effect on our Q2 games revenue. This segues into my third and final topic, a broader discussion of our Q2 results. As you know, we guided that Q2 would be a down quarter and it was even more of one than we expected. There were two major drivers of this shortfall, one was a shortfall in games revenue, largely driven by the decision I mentioned to change the business model for HM4 from freemium to free to play. The second was a delay in closing with some of our key IP deals. We still anticipate capturing the forecasted revenue related to both initiatives, but in later quarters than we previously anticipated. As I mentioned above, we continue to make progress with our growth initiatives RMHD, Kontxt and mobile games subscriptions, and are encouraged by the initial market reaction to SAFR. We expect to see revenue increase for the company in Q3 and Q4 compared to Q2. Having said that, we are seeing longer sale cycles and implementation cycles that are expected for both Kontxt and RMHD, and lower revenue for games as noted above, which will likely mean that our full year revenue for 2018 will be lower than we expected beginning of the year. Having said that, we still believe we're on track to become EBITDA positive by the end of the year. Cary will take you through both the Q2 results, and our guidance for Q3 in more detail in a few minutes. I'll add a final note on Napster. Our B2B strategy continues to prove successful with Napster reporting its fourth consecutive quarter of positive operating income. While we face a lot of competition, Napster's aligned with and benefiting from important industry and secular trends. In summary, Q2 was a mixed quarter. We weren't happy with our financial top and bottom lines months for the quarter, but we were very pleased with our strategic progress, especially regarding SAFR. We're confident that our revenue will bounce back in the second half of the year and that our growth initiatives will deliver value for both consumers and shareholders. And with that, let me turn the call over Cary.

[Cary Baker:]

Thanks Rob, and good afternoon, everyone. In my remarks today, I will first review our consolidated second quarter results followed by a more detailed discussion of our segment business performance. I will then review our expectations for the third 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 as well as 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 mobile games within 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 second quarter, revenue was $15.7 million, down 27% from $21.6 million in the prior-year period, and down 20% from $19.7 million in the prior quarter. We are disappointed that revenue fell slightly short of our expectations. As Rob discussed previously, the variability was mainly attributed to our IP licensing revenue and the shift with Heart's Medicine 4 to free to play. Looking at these results in greater detail, revenue within the Consumer Media segment was down $3.1 million year-over-year and down $1.6 million, sequentially. The majority of the year-over-year decline was related to the timing of devices shipped by an IP license partner. It is important to note that we continue to expect to achieve the full value of this contract in 2018, but in later quarters than originally forecasted. The sequential decline was related to the timing of devices shipped as well as the adoption of the new revenue accounting standard, which accelerated the recognition of revenue for certain codec technology contracts into the first quarter. Previously, revenue related to these contracts was recognized ratably over the course of the year. Mobile services revenue was down $1 million year-over-year and down $2 million, sequentially. On a year-over-year basis, the decline is primarily driven by lower revenue from our RealTimes product. On a sequential basis, the decline reflects the timing of revenue recognition of the nonrecurring elements of the Ringback Tones and RealTimes contracts that were signed last quarter. Finally, Games revenue for the second quarter was down $1.8 million year-over-year and down $300,000 sequentially. The year-over-year decrease is a largely reflective of the highly successful launch of Heart's Medicine in the prior year quarter. During the second quarter of last year, the third installment of our Heart's Medicine franchise was released. This was our most successful launch of 2017, which has created unfavorable comparisons to this quarter. As Rob noted, the next generation of Heart's Medicine will launch globally as a free-to-play version in the second half of this year. The year-over-year decline was partially offset by new revenue initiatives, including in game advertising within our mobile games. The decline from the first quarter was primarily, due to reduced product sales from our individual title launches partially offset by advertising revenue. Consolidated gross profit was $11.1 million in the second quarter, down $4.2 million over the prior year period and down $3.4 million from the prior quarter. Gross margin for the second quarter was 71%, flat from the prior period and down from 74% in the prior quarter. Operating expenses in the quarter were $17.9 million, down 3% from the prior year period, reflecting our focus on maintaining a properly aligned cost structure, including reduced headcount and facilities expense. On a sequential basis, operating expenses were down 8%, primarily reflecting reduced sales and marketing expenses. Adjusted EBITDA for the second quarter was a loss of $5.7 million compared to a loss of $1.3 million in the prior year period and a loss of $3 million in the prior quarter. Net loss was $6.9 million or $0.18 per share compared to a net loss of $3.8 million or $0.10 per share in the prior year period and a net loss of $5.2 million or $0.14 per share in the prior quarter. Turning to our second quarter segment results in more detail. Consumer Media's segment contribution margin was a loss of $500,000 compared to a gain of $2.2 million in the prior year period and a gain of $600,000 in the prior quarter. The year-over-year decline was largely due to the timing of revenue from our IP contract business for our codec technologies, which, as we have mentioned previously, tends to be lumpier in nature. Compared to the prior quarter, contribution margin was impacted by lower revenue, both the sequential and year-over-year declines were partially offset by operating expenses. Mobile Services segment contribution margin was a loss of $2.1 million compared to a loss of $1 million in the prior-year period, and a loss of $700,000 in the prior quarter. Compared to the prior year and prior quarter, the decline reflects lower revenue partially offset by reduced headcount expenses. Games segment contribution margin was a loss of $1.3 million compared to a loss of $700,000 in the prior year period, and a loss of $1.1 million in the prior quarter. Compared to the prior year quarter, the year-over-year decline was driven by lower revenue related to the performance of certain game launches in the respective periods and increased personnel expenses. This was partially offset by improved gross margin in the quarter and decreased marketing expenses. On a sequential basis, the decline reflects lower revenue in the period. At the corporate level, unallocated corporate expenses of $2.4 million, decreased by $500,000 compared to the prior year period, and decreased by $800,000 compared to the prior year quarter. The year-over-year variance reflects reduced headcount, professional service and facilities expense as a result of our ongoing cost reduction efforts. Sequentially, expenses were lower due to the stock-based compensation in the prior quarter. Now turning to our balance sheet, we ended the quarter with $42.1 million in unrestricted cash, cash equivalents and short-term investments, reflecting a sequential decrease of $12.2 million, driven primarily by the net loss and the $4.2 million acquisition of Blue Giraffe in the second quarter. I'll now turn to our outlook for the third quarter. We are encouraged by the progress we have made in the trial and deployment of our key technologies. While we are on track to recognize revenues related to our growth initiatives in 2018, our full year revenue for 2018 will likely be lower than we expected at the beginning of the year. This expectation is influenced by the longer than anticipated sales and implementation cycles 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 third quarter, we currently expect total revenue in the range of $17 million to $19 million, and adjusted EBITDA loss is expected to be in the range of minus $2.5 million to minus $4.5 million. With that, we will now open the call for questions. Operator?

[Operator:]

[Operator Instructions] Our first question comes from Dan Weston, WestCap Management. Please proceed with your question.

[Dan Weston:]

Yes, hi guys, thanks for taking the questions. Just relating to the commentary on the lower-than-expected revenue outlook for the year and simultaneously indicating that you still expect EBITDA profitability to happen sometime this year. Is it reasonable to assume that the projection just assumes the uptake of some material degree in your codec business?

[Robert Glaser:]

Well, as you know, hey Dan, we don't guide by segment. I think it's fair to say that we look at our pipeline of business across the board and feel good about not only the growth of revenue in Q3, but that trend, as I said, continue in Q4, and when you aggregate that, and you manage cost carefully, you hit a crossing point. So I think, we see significant leverage in our business model and that as our revenue grows up - goes up, obviously, not every penny goes to the bottom line, but now that we're 70% gross margin - 70% plus gross margin company, we do get a lot of leverage as we increase our business. But in terms of the mix of what that's going to be across the segments, I don't think we would typically guide on that.

[Dan Weston:]

Okay, and then on the Kontxt, is there any guidance or color you can give us in terms of when you expect to be able to produce some revenue?

[Robert Glaser:]

Again, I don't think we're guiding on particular segments, but I think we do believe that the growth initiatives that have been out a little bit longer will start to bear fruit. I mean, we already say we have some subscription revenue in mobile games, so we assume that's going to keep growing. And then, in the case of Kontxt, as we go from the stage where in now, which is really significant business negotiations with various partners to deployment. Once they're deployed, it is typical when we start to get paid and recognize the revenue.

[Dan Weston:]

Got it. Okay. If you don't mind, let me just dig a little bit on that, on the codec business and the Consumer Media, obviously that was lower than expected, and you mentioned last quarter that due to some timing of devices being shipped by one of your customers led to that lower Consumer Media revenue. Is this relating to one suspect customer? And have you seen evidence that devices are being sold into the market that gives you a little more comfort that back half of the year will pick up?

[Cary Baker:]

Hi Dan, it's Cary. So that - it's a great question. I think, what we're seeing in the consumer media business is a combination of things, one is existing contracts that are based on shipments for the full year coming through a different rates than they did previously, particularly in last year. So whereas last year, all of the shipments for an annual contract went through in 1 quarter or a couple of quarters, this year we're seeing it on a much more ratable basis. We are seeing shipments, and we are comfortable that we're going to get the full annual value of that country, it's just different than what we saw last year, and different than we anticipated when we started the year. So that's one piece and then the other piece eludes to the sales process and the longer sales cycle than we anticipated on RMHD sales - on new RMHD sales. We are anticipating that process starting to generate revenue much like we have in our other growth initiatives in the back half of this year, and just didn't happen in the first half, given the timing we launched, really at the end of last year and the process that's taken to go through that sales cycle.

[Dan Weston:]

Very good. Okay, I'll have a couple more, we'll talk off line, but real fast, when do you expect the Q to be filed?

[Cary Baker:]

Tomorrow, Dan.

[Dan Weston:]

Very good, all right thanks guys.

[Cary Baker:]

Thanks.

[Operator:]

Ladies and gentlemen, we have reached the end of the question-and-answer session and I would like to turn the call back to Rob Glaser for closing remarks.

[Robert Glaser:]

Thanks, operator. I want to thank everyone for joining us today. We've got a lot going on, as you've certainly have heard. I look forward to keeping you updated and talking to you all at our next quarterly call, if not sooner. Thanks, again.

[Operator:]

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