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GLUU: Undervalued Company With 40% Upside

|Includes: Glu Mobile Inc. (GLUU)

Recommendation: BUY. Target Price: $9.17 (Stock Price: $6.49 as of 6/18/2015, Upside: 42%)

Summary

Poised to capture the expanding global mobile game market (20% growth in the U.S. and up to 86% in South Asia and China), Glu Mobile (NASDAQ:GLUU) has a diversified game portfolio, a track record of successful acquisitions, and a debt-free balance sheet. GLUU also has a history of turning successful games into franchises to generate consistent revenue stream. Even after removing revenue of last year's big hit Kim Kardashian: Hollywood, GLUU still managed to grow its revenue by 30%. GLUU has a massive product pipeline for 2H15 with 11 upcoming releases and is ready to build on the positive momentum from last year. Last but not least, any potential operating partnership with Tencent (OTCPK:TCEHY) will significantly improve GLUU's future outlook considering the enormous Chinese gaming market.

Introduction

Glu Mobile is a pure play mobile gaming company that develops and publishes interactive gaming content for smartphones and tablets. The company began operating in San Francisco in 2001 and went public in 2007. It has eight studios that are based in California, Washington, Canada, China, India, and Russia. Its major franchise titles include Kim Kardashian: Hollywood, Deer Hunter, Frontline Commando, Eternity Warriors, Diner Dash, Racing Rivals, Tap Sports Baseball and others. Glu publishes licensed games with James Bond, Terminator, and Mission Impossible coming out in 2015. Glu will also launch additional celebrity games with Katy Perry and Britney Spears under contract. Tencent has acquired 15% equity stake in the company and taken a board seat.

Why GLUU is a buy

i. Mobile game industry is a fast growing money generating machine. Mobile users spend a significant amount of time playing games in smartphones and tablets as gamers shift from console games to mobile games. The increased adoption of smartphones and tablets also creates opportunities for topline growth.

The shift of gamer preferences from game consoles to mobile devices is tipping the power in the global video game business. While a traditional game console is not a must-have device, mobile phones are. Mobile phones and tablets, though not purchased to play games with, introduce new customers to games and provide users with the convenience to play games at any time anywhere. The global mobile game revenue is $25Bln in 2014 (~30% of total), and it's poised to overtake console games for the first time in 2015. The rapid growth is seen around the world with 20% growth in the U.S. and up to 86% market growth in Southeast Asia and China, which GLU is hoping to penetrate with the partnership with TCEHY.

There has been a major expansion of installed user base for mobile games. As opposed to market share which reflects sales over a time period, the installed user base is defined as the number of units of computing platforms actually in use, thus presenting a better measurement for potential market estimation. By 2016, the smartphone user base will triple from 2012 and tablet user base will quadruple. The user base will continue to grow as the Economist expects the percentage of adult population that owns a smartphone to increase from 50% today to 80% by 2020. Mobile device owners spend a significant amount of time playing games. According to App Annie Intelligence, among the top 500 grossing apps in the United States in terms of revenue, about 90% are games. The favorable macro factors act as a tailwind for GLUU to take advantage. The popularity of mobile games translates to higher revenue generation as GLUU's revenue increased by 20% CAGR from $79Mln in 2009 to $223Mln in 2014.

ii. TCEHY, the Chinese internet giant, purchased 14.6% equity stakes in GLUU and has a board seat. Chinese gaming market presents significant opportunities that can be captured with help of TCEHY. Any operating partnership can significantly boost GLUU's forward-looking estimates.

TCEHY, the world's largest gaming company by revenue, has acquired 14.6% equity stake in GLUU at $6 per share, and it "has the rights and the ability on the open market to purchase up to 25% in total of the shares outstanding." TCEHY agreed to an 18 months lock-up on all the shares purchased during this period. Steven Ma, SVP and Head of TCEHY's Interactive Entertainment Group, took a board seat with GLUU and will oversee cultural tastes, market social trends, sales and marketing directions. This deal gives GLUU a pro forma cash balance of $190M, which can be used to keep expanding global celebrity gaming leadership, acquire new companies, and hires new talents.

While GLUU has the potential to use its distribution expertise in the western world to bring TCEHY's Chinese games to the U.S., GLUU can also utilize TCEHY's large distribution network in China to penetrate the Chinese gaming market. This mutually beneficial relationship generates strong incentive for TCEHY in GLUU's overall success. Most of GLUU's current game franchises can be easily localized for Chinese market - they simply require adding a Chinese language setting without changing any graphics or programs. With the help of TCEHY's significant presence in Chinese gaming market, GLUU will be able to establish brand recognition and attract new users without incurring significant expenses.

Moreover, the Chinese gaming market represents one of the biggest and fastest growing markets in the world. According to Newzoo's research, 45% of total global gamers and gaming revenue are in APAC countries. For China alone, there are 173.4M gamers aged 10 to 50, among whom 86.7% play games on smartphones and 59.6% play on tablets. This would suggest an $8Bln [$81.5Bln*(173/1747)] potential Chinese mobile game market. Although GLUU currently has global presence, it generates only $35Mln, or 17% of its total revenue, from Asia (5% in China and 12% in the rest of APAC). This low percentage suggests a large headroom for GLUU to improve with the help of TCEHY. Historically, TCEHY had experiences of localizing imported games and turning them into success. For example, TCEHY acquired a controlling stake in California based Riot Games in 2011 for ~$400Mln based on a $472Mln valuation and introduced the game League of Legends to China. In the year of 2014 this investment generated $1Bln revenue for TCEHY and it is still growing. Any operating partnership with TCEHY can significantly increase upside for GLUU's forward-looking prospect.

iii. GLUU employs a game franchise strategy that has proven to be successful. A diversified product portfolio, the usage of cross-promotion, and a well-stacked pipeline of incoming releases ensure continuation of past success.

1) GLUU has a history of turning a successful game into a franchise to generate continuous revenue.

GLUU's products are "freemium" games that are free to download but offer in-app purchases for users to accelerate game progress or customize experiences. A freemium app typically generates high revenue in the first few month after its original release but slows down eventually. Once a game is well-received by the gaming community, GLUU keeps stimulating user spending by either introducing updates on in-store purchases or releasing a new version of the game. GLUU employs a franchise strategy such that each new game in a franchise requires incremental improvements instead of building something completely from scratch. R&D costs have seen consistent decrease from 60% of total revenue in 2011 to 30% in 2014. This allows GLUU to create a lower cost game pipeline and repeatedly engages users, which has proven to be successful as each franchise continues to generate revenue after its initial release, shown by the graph to the right.

2) Each franchise can be used for cross-promoting other franchises, which helps GLUU to gain exposures and introduce incremental customers to other GLUU games.

The level of critical or commercial success of the games previously introduced is an important factor to attract new customers. With over 1 billion downloads across platforms, GLUU's franchises generate brand recognition that brings new users for upcoming games. The successful release of Kim Kardashian: Hollywood and the upcoming series with Britney Spears and Jenner sisters bring additional public exposures from the social media of these celebrities. GLUU does not pay these celebrities for anything they post on their social media, and since they have millions of social media followers, this is a significant boost for brand value without GLUU spending any marketing expenses.

3) With successful acquisitions and in-house development, GLUU has built a diversified game portfolio of different genres.

GLUU has an impressive record of making good acquisitions, and was especially active in the last two years, acquiring the Deer Hunter franchise, Cie Games (Racing Rivals), PlayFirst (Diner Dash), and Pick6 (Tap Sports). GLUU has developed a diversified game portfolio that cover multiple genres, including FPS (Deere Hunter, Frontline Commando, and Contract Killer), ARPG (Eternity Warriors), narrative RPG (Stardom), racing (Racing Rivals), time management (Diner Dash) and sports (Tap Sports).

Unlike many game development companies that rely heavily on one huge hit or concentrate on one genre (such as King Digital Entertainment (BATS:KING) with Candy Crush), GLUU has proven that it can provide consistent growth without dependence on major hit games. After removing revenues from KKH and 2014 acquisitions, GLUU still has a 28.7% YoY revenue growth, again confirming GLUU's ability to continue monetizing existing non-hit franchises.

4) A massive fiscal 2H15 product pipeline should build on the past momentum and continue generating increased smartphone related sales.

The CEO said during the 4Q14 conference call that in 2015 the company would be less reliant on acquisitions and focus on internal development of sequels and/or complementary titles. The release schedule is tilted towards the second half as the development team spends 1H15 on building on success from last year and keeping the services alive. GLUU expects to launch 16 titles in 2015, and the new games will cover multiple genres (sports, ARPG, racing, and RPG), new titles (Katy Perry, Cooking Dash, Car Town Rivals, and Tap Sports Football), sequels (Deer Hunter, Eternity Warriors, Tap Sports Baseball), owned IP (Deer Hunter, Eternity Warriors, etc.), and licensed (Katy Parry, James Bond, Terminator). Although it would be difficult to replicate the success of Kim Kardashian: Hollywood in 2014, the new titles should produce a healthy revenue stream.

iv. Celebrity brand power, combined with emergent gameplay and gaming community, provides a personal gaming experience that keeps players engaged.

GLUU's mission statement emphasizes strong social brand power: "To create instantly recognizable, lasting game franchises by combining star talent and social power." One of GLUU's niche markets is casual RPG gaming that takes advantage of emergent gameplay and targets the celebrity-obsessed community as key customers. Emergent gameplay allows players to create rather than interact with the story, which grants players greater ownership. The Stardom franchise allows players to create their own game characters, customize their looks, celebrities, have an interactive adventure, and eventually make it to the stardom A-list. The fan base also creates an interactive community that generates greater revenue and increases player retention.

GLUU and Kimsaprincess, Inc. ("KAP") entered a license agreement dated Nov. 5 2013, which allows GLUU to develop and update Kim Kardashian: Hollywood (KKH). GLUU team actively stay in touch with Kim to make updates to make the game mimic Kim's real life as much as possible. The originality of the concept and Kim's efforts of promoting the game almost as much as she promotes herself has made KKH a huge success, generating $100Mln in the second half of 2014 alone. GLUU extended the licensing agreement by another three years to 2019. According to company 8K, GLUU will pay Kim a "minimum guarantee payment that is fully recoupable by Glu against royalties (~20% of revenue) that Glu would otherwise pay to KAP during the portion of the Term that begins on July 1, 2016 and ends on June 30, 2019".

GLUU doesn't rely on an existing star producing higher revenue, but rather adding new stars each year to grow the concept. To build on this strategy, GLUU has more celebrities in the pipeline for 2H15 and 2016, including Kylie and Kendall Jenner, Katy Perry and Britney Spears. The launch of Katy Perry title will be exciting as she has more than twice follows as Kim Kardashian. CEO Niccolo de Masi also said that GLUU is actively seeking celebrities in the sports world. The factors being considered include the number of followers, the relevance of the celebrity to gamers, and the terms of the licensing deal. Moreover, TCEHY as a partner will add to GLUU's global presence and make GLUU more appealing for celebrities to work with. TCEHY may also bring in Chinese celebrities. GLUU is targeting 1Bln total celebrity followers and $800Mln revenue from celebrity games in 2020.

v. GLUU has a healthy balance sheet with no debt. Management aligns interests with equity shareholders.

GLUU has a healthy balance sheet with no debt. As of 1Q15, the company has $65.7Mln cash on hand, which allows GLUU to make additional acquisitions, conduct R&D, and hire new talents. A large part (~60% for CEO) of the management's compensation is in equities, which aligns their interests with those of equity shareholders.

Risk Factors

i. If the upcoming titles are not well received by the customers, the revenue growth will be slower than expected.

ii. If the no synergetic operating relationship was realized with TCEHY, growth outlook for GLUU will be significantly negatively impacted.

iii. If current franchises lose steam and GLUU is unable to develop and publish new mobile games that achieve market acceptance, current revenue level may not be sustained.

iv. GLUU's financial result can vary significantly from quarter to quarter and is difficult to predict, which may result in large volatility for the stock price.

Valuation

Based on the guidance provided by management during 2015 Analyst Day and historical data, three scenarios are used (None of these scenarios includes any potential impact of operating partnership with TCEHY):

A base case suggests 42% upside and a price target of $9.17.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.