Glu Mobile Inc (GLUU)

·        Thesis:

o   Industry

§  View: Positive

§  Our overall industry view is positive, with a particularly positive view on the scaled publishers as well as the platform owners.

§  In mobile, sub-scale players are high risk / most likely will not survive on a standalone basis. Scaled players with back-end infrastructure and a proven process are best positioned – think VC firms, or even Citadel in the investment management arena.

§  While the industry is relatively consolidated / stable at the top (with the biggest players – think Zynga, Gluu, King, Nintendo, Tencent, etc.), there is a very long tail of sub-scale players that launch content/apps. Launching a new game or app is not particularly expensive; however, scaling that game/app with systematic marketing and continuously updating the game/app with content drops, etc. is very expensive – hence our view on scale. Ultimately, we expect further consolidation.

§  Distribution had been expanding rapidly over the past ~decade with the proliferation of smartphones. The smartphone market is now relatively ~mature / saturated. We do not expect significant incremental growth from unit adoption over the coming years, but do expect time/unit to continue to move higher.

·        Over the coming years, we do see the opportunity for next gen technological advancements (e.g. 5G) to enable new / expanded gaming formats – most notably, improved augmented reality (and likely related devices)

·        In the nearer term, PC is actually an opportunity to expand distribution

·        Take rates (by distributors) likely to come down over time (as we’ve seen in PC), benefitting the publishers / content owners. This would be a ‘gap risk’ positive

§  End market (dollars) growing ~5-10% per year, with mobile the fastest growing sub-set of the gaming industry.

§  In general, the broader market has several ‘secular’ tailwinds:

·        Demographics – younger generation plays more; more people are connected

·        Increased leisure time – time spent playing games going up

·        Online networks / communities – digital transition and online networks enable constant consumer connectivity and engagement / monetization opportunities (labeled ‘recurring revenue’) beyond the initial game sale

·        New technological infrastructure (e.g. 5G) likely enables expanded distribution networks / new gaming formats

·        Cross platform play is a natural tailwind for the industry

o   Company

§  View: Positive

§  We have a net positive company view, primarily driven by our view that the company has the scaled back-end infrastructure to become a large/growing platform in the space – but has yet to launch the games/content to actually lever those fixed costs. We believe the current new game pipeline (of yet to be launched and/or announced games) is large / relatively high quality, and the launch of these games (over the coming 12-24 months) will prove out the above thesis.

·        Zynga is a prime example of a company that has: the back-end infrastructure, the ~stable core game portfolio, and now the consistent flow of new games that incrementally layer on to the core portfolio (at high incremental margins).

o   We consider GLUU somewhere 18-24 months behind the Zynga turnaround.

·        For both companies, we believe a parallel build (internal development) and buy (M&A) strategy makes sense – in order to layer on new games/content to the core/base. Both are classic platform businesses.

§  Competitive advantage: scaled back-end infrastructure + proven process, distribution relationships (less so), developer talent (for consistent content)

§  The company has a solid core/base business with their ‘growth games,’ but a continued drag from legacy ‘catalog’ games – though the drag continues to shrink. New games should begin to layer on top of the modestly growing (~5-10%) base of growth games starting in 2Q20.

§  Base Business - Content / IP (Franchises)

·        Design Home, Covet Fashion, Tap Sports Baseball… Diner Dash (potentially)

§  New Game Pipeline

·        Disney Sorcerers Arena – End of 1Q20. Delayed a few times for refinements; expectations had been very high, but are now ~reasonable. Overall, think it will be an OK game, but not a hit. Effective marketing (known IP / Disney launches) help.

·        Originals – mid 2020. ~New category, likely a hit or miss. Putting low probability on success

·        Deer Hunter Next – 2H20. Proven IP with huge audience; significantly under-monetized. Huge potential – medium probability of high success. High probably of ~medium success.

·        Tap Fishing – 2021. Still early; like the concept and the audience naturally overlaps with Deer Hunter franchise. Solid opportunity

·        Crowdstar P3 – TBD, maybe in 2021.

§  Asia

·        Asia (China, in particular) is a large and growing market that is primarily incremental. International expansion, in general, is nascent at the company.

§  Management

·        Nick Earl – CEO – came over from EA and brought several key developers / talent. This is similar to what we’ve seen at Zynga.

§  Geography

·        Currently 85% North America, 15% RoW

o   They are way under-indexed to RoW

§  Game Mix

·        Currently ~85% Growth Games, ~15% catalog

o   Expect catalog to start to be largely irrelevant exiting 2020 – particularly with the new game launches

o   Stock

§  View: Positive

§  We have a positive view on the stock. The current stock price represents an attractive entry point, with the recent dislocation (2H19) driven by game delays (notably Disney Sorcerers Arena), previously very high/unwarranted/premature expectations (when stock was above $10 pre- any new game launches), and modest internal missteps (unforeseen rising player acquisition costs). Majority of the issues are non-recurring and/or simply a timing shift.

·        Recent earnings report (4Q19 print) saw an outsized positive reaction, primarily due to a short squeeze (seemingly pods offsides on 3^rd party data) + net positive execution / commentary on Disney. We expect the stock retraces a bit ahead of Disney game launch

·        Relatively high risk / high reward investment. Risk/reward skews positive currently, but downside case still relatively significant above $7 – should be sized appropriately.

§  We see accelerating revenues and expanding gross and EBIT margins over the coming 12-24 months, and expect a significant inflection in FCF.

·        We are expecting a combination of upside to numbers and multiple expansion

o   Numbers – 2020 guidance does not include ANY contribution from new games; however, the street has decided to back in a modest amount (~$25M) on the top line, but no incremental in EBITDA (~$41M = high end of guided range = where street is for 2020)

o   Multiple – currently trading near the low end of it’s 3yr (~since turnaround began) multiple range on both profitability and sales metrics

·        GLUU has a relatively large fixed cost base (opex / developer cost) – EBIT margins are currently below peers due primarily to game delays over the past year and size (remains sub-scale relative to ZNGA). We expect that gap will close over the coming 12-24 months as the top line scales with new game launches.

o   ZNGA recently posted 20%+ EBITDA margins. KING EBITDA margins are in the 35-40% range. GLUU should scale to 15%+ in the coming 12-24 months

§  Valuation

·        Reason for valuation disconnect – game launch issues and delays

·        Inexpensive relative to itself/history and peers

·        Wide range in upside/downside EBITDA  is based on number of games in a year + size of those new games.

o   Upside case – assumes no growth in core EBITDA (~$40M) vs. CY20, and $75M of incremental EBITDA from new games

o   Downside case – assumes no growth in core EBITDA (~$40M) vs. CY20, and $20M of incremental EBITDA from new games (3-5 over next 12-24 months)

§  Balance Sheet / Cap Allocation

·        Currently, the company has ~$127M in cash (~10-15% of market cap) and no debt. We expect the company will use the cash for M&A to scale the business, lever the fixed cost base.

o   Company guided to at least $150M+ of cash exiting 2020

§  Catalyst

·        New game launches – see above re timeline. Expect most to be initially sell the news

·        New platform launches – potentially PC expansion

·        Take rate – potential app store take rate reductions (see AAPL lawsuit)

·        Execution – given the issues in CY19, executing according to plan (which involves accelerating top line / expanding margins) should lead to multiple re-expansion closer to in-line with peers

o   CY19 saw both fundamental downgrades and multiple compression – driven by a combination of internal forecasting issues and game push-outs

·        Seasonality (Gaming) – scale up the position in March (ahead of positive seasonality), trim in August (end of positive seasonality)

·        M&A – acquirer – given the rising cash balance, and our expectation for an inflection in FCF over the coming 12-24 months, expect rising focus on M&A to scale

·        M&A – target – expect the industry continues to consolidate. GLUU is currently a sub-scale candidate. Tencent is an investor.

§  Risks

·        New game launches – inherently difficult to predict, particularly sizing / success

·        Core game degradation – degradation of core games / revenue, impairing the base

·        Cost of player acquisition has gone up

·        Costs of game development have gone up

·        Regulation

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. Further info here.