Glu (GLUU) Down After Earnings. Did Market Incorrectly React?

August 4, 2014 • Analysis • Tags:

Glu Mobile has seen a 17% drop in stock price since the announcement of their Q2 earnings release. The company posted better than expected results and increased guidance, but a surprising acquisition and lowered margins caught analysts off guard. Glu’s moves however point to the company creating a more sustainable business that will benefit shareholders in the long term. The drop in price, due to needless overreaction, provides an opportunity to grab GLUU shares at a discount.

The Good from Earnings Release  

Top & Bottom Line Growth

Glu posted Q2 revenues of $35 million, a 51% increase YoY and 7% ahead of the high end of their prior guidance. The EBITDA loss of ($0.9M) was also above expectations. The front loaded costs associated with launches of games like Kim Kardashian: Hollywood and Dino Hunter affected Q2 bottom line, a trend that is not expected to continue.

gluu q3 guidance

 

Higher Guidance

Looking ahead, Glu expects Q3 2014 to be the single largest quarter in the company’s history to date. Glu is projecting to double EBITDA of their prior record Q1 2014 quarter and see QoQ top line growth of at least 110%. Original Q3 top line guidance was roughly $40M, but the success of Kim Kardashian, Dino Hunter and the Cie Games acquisition (discussed below), has boosted revenue expectations to $85M. This is a 200% increase on a YoY basis. To put this growth into perspective, Glu expects to generate significantly more revenue in 2H 2014 than entire 2013.

The Bad from Earnings Release

Q3- Q4 Revenue Decline

Overall, Glu had an exceptional quarter by most measures, but it was not perfect. Revenues are expected to decline from the record Q3 levels due to expected revenue decline from Kim Kardashian’s game in Q4. This decline from Q3 to Q4 should not come as a huge surprise as the Kim Kardashian hit cannot sustain peak sales. It’s a result of the product cycle, so Glu must try to recover as much of the lost revenue through the upcoming releases like Diner Dash and Frontline Commando. Even with the expected decline of Kim Kardashian, Glu would still see Q4 top line growth of +40% YoY.

Declining Margins

The bigger surprise was the decline in Glu’s gross margins for the remainder of 2014. Gross margins for Q2 came in at 69%, however this figure is expected to drop to 58% in Q3, resulting in a total 62% gross margin for FY2014 (down from prior guidance of 66.8%). Management explained the lower margins as a result of higher royalty costs for license IP and higher hosting costs.

Glu faced a choice on whether to stick with original IP games or license third-party content. For 2H 2014, Glu is spending more on licensed games, including Kardashian, Hercules and RoboCop. This will make the games (and Glu as a company) more visible which will attract more players. However, Glu must pay the third party (Kim K for example) their fair share of the revenues as a royalty. This expense has affected overall margins, but has also resulted in greater revenues and earnings. It’s a tradeoff that I believe has worked to Glu’s operational advantage.

Estimating Royalty Cost

glu gross margins

 

The above assumes the top line increase ($35M) in primarily coming from Kim Kardashian: Hollywood and the increased cost of revenue is the royalty paid. A 9% drop in gross margin results in a royalty of about $6.75M (31.5 – 24.75). As a percentage of the total increase in revenue, the $6.75M figure represents ~20% (6.75M / 35M). Therefore, from the figure above, the royalty paid to Kim Kardashian could be 20%.

Glu Acquires Cie Games

At the same time as the earnings release, Glu announced that it had acquired Cie Games, the maker of the top mobile grossing racing franchise Racing Rivals. Glu agreed to pay total of approximately $100 million – $30 million in cash and $70 million in shares (at $7/share). Issuing an additional 10M share would represent an approximate 12% dilution of Glu, yet the stock is down 17% since earnings announcement. Glu acquired Cie Games at an 8x EBITDA multiple, which is relatively standard considering Racing Rivals is a leader in its respective category.

 

With Cie, Glu attains an accretive acquisition that expands company reach into a new racing category, thereby diversifying portfolio of games. As a result, Glu can reach a wider demographic and minimize development costs by adding a proven game. Racing Rivals gives Glu another top grossing game as it is currently ranked 20th in iOS, grossing more than Glu’s Dino Hunter and Deer Hunter combined.

Glu expects to have a cash balance of $47M by the end of Q3, reflecting the $30M cash cost of Cie acquisition. More importantly though is that even as a standalone Glu expects to be cash flow positive during Q3.

Conclusion

Glu’s Q2 results came in above any guided expectations while increasing future guidance. Lower gross margins are a cost of increasing both the top and bottom line that Glu had to pay. Though the company diluted ~12% for the Cie acquisition, it was a move that improves the long term outlook of the mobile gaming developer. Glu’s moves during Q2 indicate that the company is positioning itself for long term sustainable growth. To get this at a 17% discount seems like a great opportunity for perspective investors.

Glu Rating
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