RealNetworks Inc.'s (RNWK) CEO Robert Glaser on Q4 2018 Results - Earnings Call Transcript

RealNetworks, Inc. (NASDAQ:RNWK) Q4 2018 Results Earnings Conference Call February 6, 2019 4:30 PM ET

Company Participants

Laura Bainbridge - Investor Relations

Robert Glaser - Founder, Chairman and Chief Executive Officer

Cary Baker - Chief Financial Officer and Treasurer

Conference Call Participants

Operator

Greetings, and welcome to RealNetworks Inc. Fourth Quarter 2018 Earnings Call. At this time, all participants are in a 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. Please go ahead.

Laura Bainbridge

Thank you, and welcome to the RealNetworks' fourth quarter and 2018 financial results conference call. Before we begin, I remind you that some matters discussed today are forward-looking, including statements regarding RealNetworks' future revenue, gross profit, adjusted EBITDA and operating expenses on a consolidated basis 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.

In addition, today's call contains certain forward-looking statements that relate to our recent acquisition of an additional equity stake in Rhapsody International Inc. which does business as Napster. Statements that express our belief and expectations and all statements other than statements of historical facts are forward-looking and involve a number of risks and uncertainties that could cause actual results to differ materially from these forward-looking statements, including risks and statements associated with combining our business and consolidating our financial statements with Napster. We describe these and other risks in our SEC filings, including any 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 the corporate website.

Forward-looking statements made today reflect RealNetworks’ expectations as of today, February 6, 2019. 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 reconciliation of each non-GAAP financial measures to the most directly comparable GAAP financial measures, 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 made in 2018 as well as preview what's to come. Cary will then provide a more detailed financial review of the fourth quarter and full year 2018 as well as provide the outlook for the first quarter 2019. 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. Good afternoon, everyone and thanks for joining us today. We have a lot to cover, including our most recent announcement regarding Napster. As I typically do at year end, I'll step back and review 2018 as a whole, I'll then discuss the recent Napster transaction in which we doubled our equity ownership to 84%. I'll then close by summarizing where we will focus in 2019.

There are two ways to look at 2018, financially and strategically. Financially, 2018 was a disappointment. We set out to grow our revenue in 2018 and return to EBITDA profitability. We're disappointed that we did not achieve this objective. The three main reasons for this were, A, slow ramp up in expected growth initiatives; B, a significant miss in our old model premium game business that was not counterbalanced by our new subscription of free-to-play initiatives; and C, modest slippage in our portfolio legacy businesses.

From a cost and expense standpoint 2018 was on track. We enhanced our margin structure and maintained OpEx discipline reducing total operating expenses by 3% year-over-year. Strategically the results were much better and I feel very good about where we are today. We entered 2018 in the process of rolling out our key growth initiatives, SAFR, our facial recognition platform; Kontxt, our message classification anti-spam platform; RMHD, our next generation video codec and new business models, both subscription and free-to-play in mobile games.

While we thought that they were all promising, going into the year we did not know which of these would end up having strong prospects and hence our focus. We exit 2018 with clarity as to which initiatives the single largest opportunity namely SAFR and what the strategies of the other growth initiatives would be. 2018 proved to be transformative for SAFR which stands for Secure, Accurate Facial Recognition. SAFR leverages AI based machine learning to deliver highly accurate facial recognition at scale. We announced SAFR last July with a dual focus, both as a horizontal platform and with a specific focus on school safety.

Regarding school safety, we announced both some early customers and that we would make a basic version of SAFR available for free to every K-12 schools through the United States and Canada. This approach has served us very well. We have some great real use cases with satisfied school customers, it has also received a tremendous amount of attention in the marketplace with major national coverage from NBC News, The Wall Street Journal, NPR, Wired, Fast Company, the Associated Press and many more.

From a technology standpoint, the SAFR platform has been very well received. According to tests performed by the U.S. Government's National Institute of Science and Technology or NIST, SAFR ranks as one of the most accurate systems in the world, one of the fastest systems and one of the systems with the greatest consistency across difference geographic ethnicities.

Our primary commercial focus for SAFR thus far has been secure access which is a very broad market opportunity. We are very happy with the initial customers and partners who have signed up to work with us to deploy SAFR. They include Net One, one of the leading systems integrators in Japan; Seventh, a global monitoring access solution provider in Brazil; and three other global systems integrators that we've signed, but haven’t yet announced.

Overall, our pipeline of opportunity is excellent for SAFR. Having said that, one of our major learnings over the past six months is that the integration and deployment pipeline with both systems integrators and large potential customers is a multistep process. Going into 2019 we've decided to make SAFR the number one growth focus of our company. We think that over the next few years SAFR has the chance to becomes Real's biggest business and we want to make sure we're giving it the resource and focus to make that happen.

Our other growth initiatives remain important to us. Kontxt, our next generation anti-spamming message classification platform continues to build traction. Kontxt uses machine learning to identify and classify the origin and intent to messages. This information allows aggregators, mobile network operators and intercarrier networks to block spam and fishing and to prioritized route and appropriately place messages.

During Q4 Kontxt went live with Syniverse, our longstanding investment partner and we began a trial with OpenMarket, a leading multi messaging aggregator. Our partnership with OpenMarket, which we announced in late Q4, highlights our combined effort to identify and counter fraud across OpenMarket's messaging network in the United Kingdom. We look forward to both deepening our work with these partners and signing up and rolling out additional messaging partners for Kontxt in 2019.

In the case of RMHD, we continue to see the Chinese ecosystem built on relationships and content providers, chipsets, and equipment manufacturers. Our partnership with a major Chinese broadcaster CIBN continues to be the foundation of our efforts to build momentum for RMHD in China. CIBN's Mobile's affiliate Stars China has just started rolling out RMHD based live simultaneous broadcast of its most popular channels to mobile users. This version of the Stars China app is now live in all the major android app stores in China. In 2019 we expect to sign up additional broadcasters, content providers, and device manufacturers for RMHD in China.

The final [indiscernible] I still want to touch on is mobile games. 2018 was a disappointing year for premium mobile games sales for us as we pivoted from premium games to a combination of premium individual titles, advertising, in app purchases and subscription revenue. The transition was bumpier than we planned as the new revenue streams took longer to fully deploy and the premium title revenue didn’t hit our plan.

The good news is that we've learned a tremendous amount through experimentation in 2018 and are honing our focus for 2019. In particular, we're starting to see progress with our free-to-play premium mobile game offerings. In Q4 we launched Hearts Medicine for Doctors Oath, our first free-to-play title globally on iOS, and then in January we also launched it on android.

We have a second free-to-play game in early test markets and we expect to roll it out globally over the next few months. Free-to-play has become the dominant economic model in mobile games. Unlike some traditional casual game publishers, we've tried to really step back and figure out a way to bring this model to casual games in a way that consumers would embrace. While there is a lot more to do, our early results are encouraging.

I'll now turn to our recent Napster transaction which we doubled our stake in the popular music streaming service to approximately 84%. We're delighted to welcome Napster fully back into the Real family. Under Bill Patrizio's leadership over the past 18 months, Napster has done a great job both refocusing on B2B and dramatically improving its financial results. Napster has delivered six consecutive quarters of positive operating income generating over $40 million operating income through the first nine months of 2018.

The favorable pricing deal structure reflects the unusual circumstances that our phone partner Columbus Nova found itself in. In a few minutes Cary will have more to say about the details of this transaction. Going forward, Napster will continue to run independently with its own Board of Directors, strategy and management team including Bill Patrizio, who will remain at the helm as Napster's CEO. I will continue to serve as Napster Board share and look forward to continued and close collaboration with Bill and his team.

Looking at Real as a whole, combined full year revenue, including Napster would have been over $200 million in 2018. The addition of Napster adds significant scale to RealNetworks along several important dimensions. Combined with our promising growth initiatives, especially SAFR, I believe that Real is better positioned for the future [indiscernible] since our return to [indiscernible]. It's taken significantly longer than expected, but I feel very optimistic about our future prospects.

So with that, I'll turn it over to Cary to discuss our fourth quarter and full year results in greater detail. Cary?

Cary Baker

Thanks Rob, and good afternoon everyone. In my remarks today, I will first review our consolidated fourth quarter results followed by a more detailed discussion of our segment business performance. I will then review our consolidated full year results and our expectations for the first quarter of 2019.

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. We will continue to update you on these timing impacts and their implications.

Turing to our results from continuing operations, for the fourth quarter revenue was $16.6 million, down 6% from $17.6 million in the prior quarter and down 12% from $18.9 million in the prior year period. We were disappointed to fall short of our revenue guidance for the quarter. As I will discuss later, the shortfall relative to our guidance was primarily related to the games segment and the later than forecasted releases in our mobile games business.

Looking at these results in greater detail, revenue within the Consumer Media segment was down $700,000 sequentially and down $1.7 million year-over-year. On a sequential and year-over-year basis the decline is primarily due to lower revenue from our IP codec business. In the current quarter, fewer devices embedded with our codec technologies were shipped than in the prior quarter and prior year periods. The sequential and year-over-year revenue declines were partially offset by revenue related to a contract renewal in the quarter.

Mobile Services revenue was down $400,000 sequentially and down $300,000 year-over-year. On a sequential and year-over-year basis, the decrease is primarily driven by a decline in our legacy ringback tones product.

Finally, Games revenue for the fourth quarter was up $100,000 sequentially and down $400,000 year-over-year. In the fourth quarter we released one fewer title than previously forecasted and certain titles were released later in the quarter than previously forecasted. On a sequential basis the revenue improvement reflects growth in our mobile games business. Year-over-year the revenue decline is primarily due to the decline in our legacy PC subscription business partially offset by new revenue initiatives including in-game advertising and the release of our first free-to-play game.

Consolidated gross profit was $12.8 million in the fourth quarter, down $500,000 from the prior quarter and down $1.1 million from the prior year period. As a percentage of revenue gross margin was 77%, up from 76% in the prior quarter and up from 74% in the prior year period. Gross margin in the quarter benefited from the release of certain liabilities related to our legacy music business. Compared to the prior quarter this improvement was partially offset by lower IP license revenue which has higher margins.

Operating expenses in the quarter were $18.4 million, up 1% on a sequential basis and down 1% from the prior year period. The sequential increase is attributed to investments in our sales and marketing to support our growth initiatives. The year-over-year increase is driven by our ongoing cost reduction efforts in our legacy businesses including reduced headcount. Adjusted EBITDA for the quarter was a loss of $4.1 million compared to a loss of $3.4 million in the prior quarter and a loss of $3.6 million in the prior year period.

Net loss was $6.9 million or $0.18 per share compared to a net loss of $6 million or $0.16 per share in the prior quarter and a net income of $400,000 or $0.01 per share in the prior year period. It's worth highlighting that net the income from continuing operations in the prior year quarter 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 fourth quarter segment results in more detail. Consumer Media segment contribution margin was a loss of $400,000 compared to a gain of $400,000 in the prior quarter and a gain of $1.3 million in the prior year period. Compared to the prior quarter and the prior year period, the decline reflects lower revenue in our IP licensing business.

Mobile Services segment contribution margin was a loss of $1.9 million compared to a loss of $1.3 million in the prior quarter and a loss of $1.6 million in the prior year period. Compared to the prior quarter and the prior year period the decline reflects lower revenue mainly related to legacy businesses and additional spend related to our growth initiatives.

Game segment contribution margin was a loss of $800,000 compared to a loss of $1.1 million in the prior quarter and a loss of $1 million in the prior year period. Compared to the prior quarter the improvement primarily reflects higher revenue and lower spend in headcount and marketing. At the corporate level, unallocated corporate expenses of $3 million increased by $500,000 compared to the prior quarter and were flat with the prior year period. The sequential increase is due to professional fees related to the acquisition of a majority interest in Napster.

Now let's look at our full year 2018 results. Revenue for the full year was $69.5 million, down $9.2 million from the prior year. Consumer Media revenue was $18.2 million, down $4.4 million compared to the prior year. Mobile Services revenue was $29.7 million, down $1.1 million compared to the prior year and Games revenue was $21.7 million, down $3.7 million compared to the prior year. Gross profit was $51.8 million for the full year, down $3.8 million from the prior year. Gross margin for the full year was 74%, up from 71% last year reflecting continued operating efficiencies and cost of revenue predominantly in our games and mobile services businesses.

Operating expenses for the year were $74.1 million, down 3% from the prior year, primarily due to reduced restructuring costs and our ongoing cost reduction efforts in our legacy businesses including reduced headcount. Adjusted EBITDA for the year was a loss of $16.3 million compared to a loss of $12 million in the prior year. Net loss from continuing operations for the year was $25 million or minus $0.66 per share compared to a net loss of $17.4 million or minus $0.47 per share in the prior year.

Now turning to our balance sheet. At December 31, 2018 we had $35.6 million in unrestricted cash, cash equivalents and short term investments compared to $60 million last year. The year-over-year decrease was due to our ongoing cash flows used in operating activities and through the April 8, 2018 acquisition of Blue Giraffe a Netherlands based game development studio.

On January 18, 2019 we acquired the debt and equity interests in Rhapsody International which does business as Napster from Rhapsody Applebee LLC, an entity managed by Columbus Nova Technology Partners for or CNTP. Following the transactions, RealNetworks has become the majority owner of Napster with approximately 84% of the outstanding stock up from RealNetworks' previous stake of approximately 42%. In exchange for the CNTP managed equity debt and other interest in Napster, RealNetworks committed to pay $1 million upfront and an additional $14 million over time subject to certain conditions with additional consideration depending on subsequent events for a total of up to $40 million.

The entity managed by CNTP would receive the full $40 million consideration in the case of a sale or similar liquidity event within the next five years where the total equity value of the 42% equity interest acquired would exceed $60 million. Additional details can be found in the 8-K filed in connection with the transactions.

As we noted in our earnings release, we will begin consolidating Napster's financial statements effective January 18, meaning that Q1 will reflect our first consolidated income statement. The consolidation of Napster's financial statements will also result in our recognizing its balance sheet which will cause our consolidated liabilities to increase significantly. However, we thoroughly consider these implications in making the decision to acquire Napster and we're confident that the long term strategic value substantially outweighs the immediate impact of consolidation. Additional details regarding Napster's financial performance will be forthcoming in our supplemental 8-K disclosure in early April.

I'll now turn to our outlook for the first quarter. We remain encouraged by the progress we have made in the trial and deployment of our key technologies and the disciplined approach to investing in our growth initiatives. We believe our strategic initiatives to drive top line growth are progressing, although with longer than anticipated sales and implementation cycles.

We expect to recognize additional revenue related to our growth initiatives in 2019 and expect our improved cost structure better positions us to scale revenue across our organization. Please also note that beginning in the first quarter of 2019 we will include Napster as an additional business segment in our consolidated financial statements from the acquisition date of January 18.

As such, we have accounted for Napster including the non-controlling interest and deal related expenses in our guidance for the first quarter of 2019 which is as follows. Total revenue is expected to be in the range of $40 million to $43 million and an adjusted EBITDA loss is expected to be in the range of minus $5 million to minus $8 million. We expect Q1 will represent the low point for revenue and adjusted EBITDA in 2019 as going forward we will have a full quarter contribution from Napster and we expect to scale our growth initiatives throughout the year.

With that, we will now open the call for questions. Operator?

Operator

Thank you. [Operator Instructions] 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 everyone for joining the call today. It's continued to be a very busy time with exciting initiatives in front of us and we look forward to updating you on our continued progress and staying in touch. Thank you all very much.

Operator

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

Question-and-Answer Session

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