Zynga (ZNGA) Frank D. Gibeau on Q2 2016 Results - Earnings Call Transcript

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Zynga, Inc. (NASDAQ:ZNGA) Q2 2016 Earnings Call August 4, 2016 5:00 PM ET

Executives

Frank D. Gibeau - Chief Executive Officer & Director

Analysts

Rebecca Lau - Zynga, Inc.

Brian J. Pitz - Jefferies LLC

Richard Greenfield - BTIG LLC

Eric J. Sheridan - UBS Securities LLC

Michael Hickey - The Benchmark Co. LLC

Doug Creutz - Cowen & Co. LLC

Christopher David Merwin - Barclays Capital, Inc.

Ryan Goodman - Bank of America Merrill Lynch

Operator

Good day, ladies and gentlemen, and welcome to the Zynga's Second Quarter 2016 Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. And as a reminder, this conference is being recorded.

I would now like to hand the floor over to Rebecca Lau, Zynga Investor Relations. Please go ahead.

Rebecca Lau - Zynga, Inc.

Thank you, and welcome to Zynga's second quarter earnings call.

As you've seen, we published our quarterly earnings letter on our Investor website so that we can increase the time you have with Frank Gibeau, our Chief Executive Officer; and Michelle Quejado, our Interim Chief Financial Officer, to answer questions. Shortly we will open it up for live questions.

During the course of today's call, we will make forward-looking statements related to, among other things, our business plan, strategy and expectations for future performance, including our guidance for Q3, and our plans for our game slate and launches in 2016.

Actual results may differ materially from the results predicted. Factors that could cause or contribute to such differences are detailed in our press release, quarterly earnings letter, and under the caption Risk Factors in our Form 10-Q and 10-K and elsewhere in our SEC filings.

We will also discuss non-GAAP financial measures. Our quarterly earnings letter, press release and the investor presentation on our website, and when filed, our 10-Q will include reconciliation of GAAP and non-GAAP financial measures. Please be sure to look at these reconciliations, as the non-GAAP measures are not intended to be a substitute for our GAAP results.

This conference call is being webcasted on the Internet and is available through the Zynga's Investor Relations website. An audio replay of this call will also be available on our website in a few hours.

Now, I'll turn the call over to Frank for his opening remarks.

Frank D. Gibeau - Chief Executive Officer & Director

Good afternoon, and thank you for joining us for Zynga's Q2 earnings call. Earlier today, we released our quarterly earnings letter, which details our progress and performance over the last quarter.

We are continuing to make great progress in our turnaround. In Q2, we launched four new games, including the successful release of NaturalMotion's highly anticipated CSR2. Our top live services saw growth, with Words With Friends, Social Slots and Zynga Poker delivering strong results this quarter.

We are tightening our operating model and improving our cost management as we do more with less, particularly in marketing. While we have more work to do in our turnaround, I'm encouraged to see the momentum we feel in our products and company show up in our results.

Our Q2 bookings were above the high end of our guidance range at $174.7 million and our adjusted EBITDA was above our range at $11.6 million. Key factors that drove adjusted EBITDA ahead of our guidance included better-than-expected bookings driven by our key franchises Words With Friends, Slots and Zynga Poker. Their combined mobile bookings were up 33% year-over-year and 2% quarter-over-quarter. And we delivered lower operating expenses, driven by a 14% lower sequential marketing spend, as we focus on achieving a higher return on investment for our marketing dollars.

One of the key highlights for the quarter was the release of CSR2. The game has been well received since its launch, having garnered more than 600,000 five-star reviews across the App Store and Google Play. Fans are responding positively to the game's stunning visuals and compelling player-versus-player racing experiences, with more than 264 million miles raced already in the game.

The CSR franchise is now the top grossing racing franchise in 2016. As the game transitions from its launch period to live operations, we plan to sustain it with a robust roadmap, delivering new supercars, tracks and more social features to fans.

While we are pleased with the results we achieved in Q2 across our products and financials, we did not make as much progress in increasing our audience. We had 15 million mobile DAUs in Q2, a decline of 7% from the March quarter. Mobile now represents 82% of total DAU.

The performance of games such as Words With Friends, Looney Tunes Dash!, Empires & Allies, and Clumsy Ninja accounted for the majority of the mobile DAU declines. Historically, Words With Friends experiences a seasonal audience decline in Q2, following increased post-holiday installs and engagement in Q1.

The declines Words With Friends saw last quarter were less than half of the audience drop the game had in Q2 2015. Looking ahead, we expect our audience metrics to fluctuate as we launch new games and our older mobile titles and Web games decline.

Looking at our product slate for 2016, we have launched eight games so far this year. We plan to launch Farmville: Tropic Escape in late Q3, and are actively updating Dawn of Titans based on soft launch feedback and are excited to bring this game to action strategy fans worldwide this holiday season.

Players are responding well to the game's high-fidelity graphics and combat gameplay. We will use the remaining time between now and the launch to focus on the game's long-term engagement and social features.

Going forward, we are prioritizing quality over quantity with our release slate. As a result, we have decided to stop production on our current version of CityVille Mobile and removed the game from our product slate. We believe the brand has incredible potential, and this version of the game was not living up to our expectations. The game was originally schedule to launch later this year. We remain very committed to the CityVille franchise and believe Invest Express is a strategic category for Zynga long-term.

In terms of our guidance, we expect Q3 bookings to be in the range of $180 million to $190 million. We expect adjusted EBITDA to be between $12 million and $16 million.

Drivers affecting our Q3 bookings include the recent launch of CSR2, the launch of Farmville: Tropic Escape later in the quarter, and the anticipated sequential growth in our key mobile franchises, partially offset by the continued pressure on older mobile titles and Web games. Additionally, we expect growth in Q3 advertising bookings rising slightly over Q2 levels. This will be driven by seasonal trends in CSR2.

As we look at our adjusted EBITDA expectations, there are a few points to keep in mind. We anticipate that gross margins could come down modestly driven by a bookings mix that is increasingly derived from mobile. We are expecting a slight sequential increase in our non-GAAP operating expenses above the $118.2 million we reported in Q2, primarily due to higher marketing expenses. We do not expect non-GAAP operating expenses to be above Q1 levels.

The modest sequential uptick in our marketing is driven by spending to support the recent launch of CSR2 and the upcoming release of Farmville: Tropic Escape, as well as greater seasonal spending as we enter the holiday.

Finally, we have completed all of the action items in our $100 million cost savings/cost avoidance plan that we announced last year. That said, we continue to evaluate all cost saving opportunities to be diligent in improving our overall margins.

Our focus continues to be on growing our live services, delivering high-quality new games and increasing our operating leverage. As a result, we believe we can grow adjusted EBITDA bookings and audience. And in fact, over the long-term, we continue to believe that our adjusted EBITDA margin will be in line with our peers.

We are in a dynamic and growing industry that has seen significant changes over the last six months. The power and capabilities of mobile devices continued to increase and players are eager for new experiences that push the boundaries of technology.

Mobile games today are bringing in a new mass-market audience, and changing how people interact and socialize on a daily basis. It's clear people want to put more play in their day and are looking for new ways to be social. Zynga's mission to connect the world through games is where mobile gaming is going, and we believe we will be a leader in this growing industry.

With that, I'd like to turn the call over to the operator and get started on questions. Thank you.

Question-and-Answer Session

Operator

Thank you. Our first question comes from the line of Brian Pitz from Jefferies.

Brian J. Pitz - Jefferies LLC

...on the revenue side as well as on the cost side to get there? Thanks.

Operator

Brian, are you there?

Brian J. Pitz - Jefferies LLC

Yeah. Hey, there. Thanks for the question. On a consolidated...

Operator

He seems to have had another conference broadcasting from his line. That's unusual. I'll move on to the next question. Our next question comes from the line of Richard Greenfield from BTIG. Richard, your line is open. Could you check your mute button?

Richard Greenfield - BTIG LLC

Hi. Sorry about that. When I was thinking about the improved performance that you talked about in your operating business and the amount of cash that Zynga is sitting on, just trying to understand, are there really benefits to being a public company?

It seems like you're in a pretty good position, either yourselves or with partners, to look at being private that would allow you to transform the company without the public eye. I guess, especially if you're looking at a multiyear transformation, is there a reason really, as you've sat through and really looked through and dug into the operations and the turnaround, what's the benefit to being public that you see right now?

Frank D. Gibeau - Chief Executive Officer & Director

Well that's a great unexpected question to start with, but thank you. Five months into the job, I've been focused primarily on getting the studio in a position to create high-quality innovative games that really brings the social gaming vision that we believe is possible on mobile devices to life, and to start to build an operating model and organization that can deliver that predictably in a highly leveraged way.

And as we look at our capital allocation and our position in the marketplace, we're very pleased with what we have in front of us as an opportunity to grow, in conjunction with our shareholders and with our teams.

And so it's not something that we think about. We're actually looking at how do we take a company that has a fantastic balance sheet, an amazing collection of brands, and engaged and passionate audience, and a compelling market opportunity with a growing and expanding and innovative market cap, that will allow us to create a great company.

And as we think about our turnaround and where we're at right now, we see so much potential and opportunity in what's possible here. And so, from our perspective, we're not really looking at a different configuration. We believe that we can operate better as a company and create real value for shareholders and be a profoundly powerful company in the market.

Richard Greenfield - BTIG LLC

And just a follow-up on that. As you look at kind of the cost structure side of it, is there any way to size when you look at the core games that are generating your EBITDA?

I assume that there's meaningful subtractions from there given your overhead, meaning teams working on games that either haven't worked or aren't working well enough. Is it possible to still cut the company down by 50% in terms of employees? Like, do you need these many employees when you look at your peer group, which seem to be far smaller from a sizing standpoint?

Frank D. Gibeau - Chief Executive Officer & Director

We look forward to bringing more products to market that innovate and create new audience opportunities and set new standards. And we believe that we can do that in new ways that will increase the KPIs and benchmarking versus our competitors.

So I like the teams that we have. We've been aggressively adjusting to a smaller, more strategic slate, fewer, bigger, better. And as we go through that process we are evaluating which teams have the opportunity to win and where Zynga can be successful in scale, and frankly, being very disciplined about starting to get out of things that don't make sense for us and adjusting our talent base to be best deployed on the biggest ideas.

So we are going to constantly look at our R&D, our G&A and our marketing and sales, and get that into a place where we are competitive with our competitors and in a place where we have leverage going forward and can grow in really interesting ways. So, five months in, I do see a lot of operating leverage still to be delivered and to be explored.

Richard Greenfield - BTIG LLC

And just if I could ask one more, and humor me, when you look at CSR Racing 2, you seem very excited by the early progress. Just wondering, when we look at the App Store data in terms of top grossing and see that it has been declining kind of week-by-week, what gives you confidence that it's working? Is there something that we're not seeing in the aggregate roll-up data that's really encouraging to you, or even in other countries relative to what you're seeing in the U.S., et cetera?

Frank D. Gibeau - Chief Executive Officer & Director

Yes. It's hard to know which chart you're talking about there, but on a global basis across all markets, including in-app purchasing as well as advertising, we're very pleased with the performance of CSR2 out of the chute. And we're watching it on a daily basis and putting together robust live ops plans to be able to sustain that success.

It is early days for the title, and it's in a category in racing where it is performing very well, and it's growing well past its competitors. It is early days, though, and we're watching it very carefully to make sure that we can sustain that over the long-term.

Richard Greenfield - BTIG LLC

Thanks so much.

Rebecca Lau - Zynga, Inc.

Thank you. Operator, next question?

Operator

Thank you. Our next question comes from the line of Brian Pitz from Jefferies.

Brian J. Pitz - Jefferies LLC

Thanks for the question. I think just a few more on CSR. Can you talk about the revenue split between ads and in-app purchases, and also how did the ads in CSR compare to other games like Words With Friends?

And then, just separately, given the success of CSR, just curious if you're getting more optimistic around other titles from NaturalMotion, including Dawn of Titans, right now? Thanks so much.

Frank D. Gibeau - Chief Executive Officer & Director

Well, look, I'm a big believer in NaturalMotion. I've been out there several times since I joined the company and it's a fantastic studio, really talented people, and they do things in their games and on mobile devices that nobody else is doing.

So I think CSR2, as a long anticipated release from them, has come out and has done very well on a quality standpoint and is really engaging with fans. And as we grow it in live ops, I'm excited about what the potential is there.

We're not really breaking out the in-app purchase versus advertising pieces. We look at the majority being from in-app purchase, but advertising is a nice piece of that. Whereas in Words With Friends, the majority of that revenue is, obviously, from advertising.

As you look forward to Dawn of Titans, a lot of the things that we're doing in terms of looking at the game teams, enabling the technology, spending the right time in soft launch to look at what's working from a feature standpoint, a lot of the learning that we've gone through on CSR2 is clearly being deployed on Dawn of Titans.

And we have the time between now and launch later this holiday season where we're spending a lot of time really looking out what's it going to take to deliver on the great quality that Dawn of Titans is already demonstrating in its gameplay and visual look, but really be able to show that it has a long-term engaging game model that allows us to keep customers engaged over the weeks, months and years that we think that that franchise can create.

Brian J. Pitz - Jefferies LLC

Thanks so much.

Rebecca Lau - Zynga, Inc.

Operator, next question?

Operator

Thank you. Our next question comes from the line of Eric Sheridan from UBS.

Eric J. Sheridan - UBS Securities LLC

Thanks for taking the question. Maybe two. One, obviously we've seen the success of Pokémon GO. Wanted to know what that might mean for the way in which you guys go at sort of designing games or thinking about the interactivity of games in terms of the way they launch and the way you create engagement around the games and the franchises going forward?

And then second, on the advertising business. Appreciate the color on some of the bigger partnerships. Maybe you could dive a little deeper there and help us understand how some of those advertising partnerships might evolve not only this year, but as we move into 2017. Thanks so much.

Frank D. Gibeau - Chief Executive Officer & Director

Sure. Look, I think Pokémon is an amazing phenomenon, and I think it's really come in and helped change expectations, and frankly, the analysis of what was going on in mobile. They really shook it up. They burst into the top of the charts, and they did it in an innovative way.

At its core, it's an incredibly innovative product on an augmented reality level with a great brand. But what was really inspiring to us at Zynga is how social the game is, and how much it enables group play and communication and trading and conversation and ways to interact in new ways.

We find that incredibly interesting and inspiring and, in fact, is really in tune with the social vision of our company, which is we believe that, on mobile devices, building a game from its inception, thinking about it as social and a game where you can play with your friends and family, and games for busy adults, games for people that don't necessarily click on game ads. This is the vision of our company is to build products like that, and Pokémon really points to that direction and validates a lot of those things.

We've also been doing research in the types of technologies that are coming online, as you get more power in the phones and possibilities in these platforms that we're also excited about. So we're going to have more ways to interact with our fans. Our fans are going to have more ways to interact with each other. And it feels like it's definitely in the direction that we're trying to take the company.

In terms of advertising, we have a lot of network partners obviously, and we're always looking at new networks to bring on line, both nationally and internationally. We look at their reach and their impact, and we're very focused on that piece. But we also have a great collection of brand partners with Pepsi, Disney, Progressive, McDonald's.

And we really are innovating with new ad products for those partners. And we're constantly on the hunt for brand partners that are looking to do new things in interactive as well as on mobile devices. So I feel very good about the business that we've built up over the last several years in advertising and we have several new ad products that we're actively innovating on right now with brand partners.

Operator

Thank you. And our next question comes from the line of Mike Hickey from The Benchmark Company.

Michael Hickey - The Benchmark Co. LLC

Hey, Frank. Great quarter. Thanks for taking my questions. It sounds like, if I heard you right, you've completed your cost reduction plan, and I think that's ahead of schedule. Curious then sort of how you sort of balance your current strategic focus when you think about the importance of bookings versus margin expansion in sort of the near-term?

And then I believe, in your prepared remarks, you said over the longer term you have achieved margin in line with your peers. I was hopeful you could sort of clarify maybe a time period there and what, if you have, any sort of specific margin objective. And I have a quick follow-up. Thanks.

Frank D. Gibeau - Chief Executive Officer & Director

Sure. The goal with the cost reduction/cost avoidance program has been completed and has set the company in a configuration that we believe can be successful. However, we are going to continuously improve and continuously evaluate all of the investments that we make and the deployments that we have.

So, as we look forward into Q3 and beyond as a company, our goal is to continue to drive efficiencies in R&D, in G&A, in marketing and sales, as I said earlier. And I think that some of the early work that we've done in marketing by raising our expectations in terms of what's possible with ROIs, our buying behavior, our deployments, is starting to show benefits. And I think there's further work possible in other parts of the P&L.

As we look at how we grow bookings and margin, we really think about audience as well. I know that was something that we talked about in the letter and in a couple of the questions. We want to combine all three into a very balanced growth plan, where we're getting high-quality bookings, not just buying any bookings at any cost, where we're looking at margin through – really evaluating our location strategy, our deployments in R&D, G&A and marketing and sales, and then starting to put out hotter products, more innovative products that have better chart performance to drive better bookings.

So the combination of those elements is what we're looking at as we're putting together our slate for the next couple of years. And that combination of elements, and then executing and doing what we say we're going to do, should put us into the conversation with the other top game companies in terms of their EBITDA margin performances, which if you look at the Activision's, the EA's, King before they were bought, Exxon's, the others', that's the range that we're really interested in getting after.

In terms of the timetable, we're really going through that exercise now to figure out what's possible. And honestly, I'd like to get into a couple more quarters under our belt here to see how we're operating and be able to give you guys more visibility into that as we finish up the second half year and be able to talk more long-term.

Operator

Thank you. And our next question comes from the line of Doug Creutz from Cowen & Company.

Doug Creutz - Cowen & Co. LLC

Thanks, Frank. You were certainly a veteran of the transition of an industry the fewer (23:19) bigger titles and your time with EA with the console side. And I think it's fair to say we're starting to see that on the mobile side as well. And one of the areas where people have been successful is really introducing a lot more live ops into their games. Can you talk about where you see opportunities for that in your casino slots business where you've had a fair amount of success?

Frank D. Gibeau - Chief Executive Officer & Director

Hey, Doug. Thanks for the question. I think there's a real big opportunity in our slots products to add new features, systems that really extend the long-term engagement of the players. There's a lot of RPG mechanics, a lot of VIP and loyalty program opportunities, where we can go a lot deeper on the feature sets in our slots games that I believe will drive higher levels of engagement, and also allow us to kind of recapitalizing and reacquire customers more effectively.

So I consider that kind of product innovation that drives organic installation and organic audience growth, and it's one of the things that we're trying to balance with paid acquisition, as we want to raise our expectations on what's a good ROI for a paid acquired customer and drive more customers through product innovation, social features, getting people the opportunity to share more in their games with their friends and family to invite them in to play competitively and cooperatively with them.

And so I've had some experience with moving through that model in my career, and I see a real opportunity here with our slots business for sure going much deeper on product innovation and feature-depth innovation.

Doug Creutz - Cowen & Co. LLC

Great. Thanks.

Operator

Thank you. And our next question comes from the line of Chris Merwin from Barclays.

Christopher David Merwin - Barclays Capital, Inc.

Hi. Great. Thank you. I just had a couple. So I know it's still early days for CSR2, but maybe can you talk a bit about how engagement has been trending for that title? I know long-term engagement is a key focus for the company now. So, after the initial buzz and marketing launch, can you just talk about what you're seeing on the long-term engagement front and how confident you are you'll be able to sustain those levels going forward?

And then, just a more specific question on the cost cutting. I know I think you mentioned much of those efforts have been completed. What are those efforts? I believe it was relocating people into lower cost regions. So is that process also fully completed, or is there perhaps more you can do there as well? Thank you.

Frank D. Gibeau - Chief Executive Officer & Director

Sure. With CSR2, at its core it has a player-versus-player racing mechanic that is really addictive and really fun, and keeps people coming back, because it allows them to continue to unlock new cars, parts, but also within their guilds or crews, they can actually race against each other. And we see that's an area where there's a lot of heat with players, and the players that are the most highly engaged are the players that are deep into the multiplayer PTP mode.

I'm a big fan of those types of modes in the more action strategy games. So we see that's an area of opportunity. There's also a high demand – we've actually put out a couple of recent car releases. We have a new car release next week. So, as we do more content upgrade, there's a lot of great opportunities for reactivations or continuing to keep people who are more single-player-oriented engaged in the product. But it's got very strong engagement for the racing category, which is super cool, and we're going to continue to build on those two key areas in content and PTP to keep the product alive for a very long time.

The original CSR's installed almost 190 million times. And so there's a very large audience for us to continue to acquire and continue to reactivate and market to. So we're excited about that long-term.

In terms of the location strategy and costs, to be honest, the announcement of the conclusion of that cost exercise does not mean that we're not done looking at cost at this company. No way. There's a lot of opportunity, I believe, in us looking at our location strategies, how we build games, how we market games, and then how we support the teams that are doing that.

One of the things that's pretty cool about Zynga is that we are dispersed on a geography level. We have a large group in India, almost 400 people that work on our products there. We've got low-cost centers in places like Toronto and other parts of the world, where we have critical mass and our studios are in those places. And we are actively looking at ways to maximize that deployment and grow in a way that is getting the best talent. We got to go where the best talent is, but also getting maximum leverage from the folks that we do engage.

Rebecca Lau - Zynga, Inc.

Operator, next question?

Operator

Thank you. And our final question for today comes from the line of Ryan Goodman from Bank of America.

Ryan Goodman - Bank of America Merrill Lynch

Hey. Thanks for taking the question. I'm here for Justin Post today. Quick question just on the ad business really, it's been putting up some very nice growth. So, as we look ahead, I'm just trying to understand what some of the drivers are here?

Just is there room to go and just increasing the ad loads with the existing game base and user base? Or are we looking – is it more about getting new types of ads out there? Or is it really just about getting user growth and new games into the market?

Frank D. Gibeau - Chief Executive Officer & Director

Honestly, it's all of the above. We're actively innovating in our biggest ad product, which is Words With Friends, to increase opportunities there. We're looking at constant optimization of our network partners, leveraging kind of the RTV channels, looking at our direct team and figuring out more partners to bring on and what kind of products our partners are looking for.

So, again, I'm very pleased with the potential that we have in advertising and expect that we will be innovating on a product level and on an inventory level. And as we release titles like CSR2 or future products in the brain puzzle category or in some of our casual areas, we'll have a real great opportunity to do more things like watch-to-earn, which is a very leveraged ad product for us. So it's a pretty cool part of our company.

Ryan Goodman - Bank of America Merrill Lynch

Okay. One quick follow-up on that. Are you able to share how the margins of the advertising revenue stream compare to the broader business?

Frank D. Gibeau - Chief Executive Officer & Director

We don't really go into that level of depth.

Ryan Goodman - Bank of America Merrill Lynch

Okay. No worries. Thank you very much.

Frank D. Gibeau - Chief Executive Officer & Director

Well, thank you everyone for your questions today. And we look forward to talking to you on our next quarterly call.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect. Everyone have a good day.

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