Inspired Entertainment Inc (INSE) 2019 Q1 法說會逐字稿

Good morning, everyone, and welcome to the Inspired Entertainment First Quarter 2019 Conference Call.

(Operator Instructions) Please note, today's event is being recorded.

I'll begin today's conference by referring you to the company's safe harbor statement that appears in the first quarter 2019 earnings press release, which is available in the Investors section of the company's website at www.inseinc.com.

This safe harbor statement also applies to today's conference call as the company's management will be making certain statements that will be considered forward-looking under securities laws and rules of the SEC.

These statements are based on management's current expectations or beliefs and are subject to risks, uncertainties and changes in circumstances.

In addition, please note that the company will discuss both GAAP and non-GAAP financial measures.

A reconciliation is included in the earnings press release.

With that completed, I would now like to turn the conference call over to Lorne Weil, the company's Executive Chairman.

Mr. Weil, please go ahead.

Thank you, operator.

Good morning, everyone, and thank you for joining our first quarter earnings conference call.

With me this morning on the call are Brooks Pierce, our President and COO; Stewart Baker, CFO; and our newly minted Group Chief Technology Officer, Steve Beason, who will say a few words on the call this morning.

As described in the press release, our first quarter adjusted EBITDA results were in line with our previous guidance.

Total revenue appeared to be down year-over-year on a reported basis mainly because of foreign exchange rates and some nil margin sales and nonrecurring software licenses in the comparable quarter last year.

If anyone is interested, we can explain the issue of nil margin sales in the Q&A.

However, if we exclude these onetime sales, our revenue increased $3.7 million or 11% on a functional currency basis, which is a far more accurate measure of the momentum we see in the business.

In terms of outside research projections, we were at or ahead not only on adjusted EBITDA, but both year-to-year and the sequential quarterly adjusted EBITDA growth and maybe, most importantly, operating margin improvement.

Adjusted EBITDA for the quarter was up 18.5% year-over-year on a functional currency basis to $13.7 million, which is about in the center of the guidance that we had given in the first quarter of between $13.25 million and $14.25 million.

We were pleased with the continuing strength in adjusted EBITDA margins, which went from 36.6% to 40.7% year-to-year, which we see as a very positive sign.

During the quarter, revenue in Virtual Sports, our best performing segment in terms of margins and return on capital, increased 11% year-over-year on a functional currency basis.

Our existing content portfolio continued to perform extremely well in the first quarter.

And during the second quarter, we added Virtual Basketball.

If you had a chance to see this game, either online where you can see demos of it or one of the recent gaming shows, I guess, most recently, the ICE show in London, I think you'll agree that visually, it is our best product to date.

And indeed, the reception to the graphics and animation have been tremendous.

No lesser authorities than my 13-year-old son and a legion of his friends have grudgingly conceded that they preferred the graphics of Inspired Virtual Basketball to the legendary NBA 2K, to which they are all addicted.

And no doubt, although generally we don't like to get 8-year guidance around here, I would expect a strong uptick in our business about 8 years from now when today's cohort of 13-year-old comes of age.

We have just signed our first Virtual Basketball customer, a major global online operator on the Interactive side, and we're expecting to be in a number of retail venues later this summer.

This is a product that has been highly waited and anticipated by the marketplace.

If have been following the NBA playoffs, in general, and the Milwaukee Bucks in particular, you can imagine the impact of basketball mania in Greece, one of our primary markets with over 4,000 retail outlets.

I should also mention on the issue of Virtual Sports development, and I'm particularly enthusiastic about this, being as some of you might know, Canadian, we're hard at work on our hockey game as a follow-up to basketball.

And we expect to show this game at G2E this coming fall for any of you who intend to be there.

On the Interactive side, we're impressed, though not necessarily surprised, at the demand we're seeing for our slot and Virtual Sports content online and on mobile.

In fact, online currently represents about 40% of total Virtual Sports revenue.

The leading global operators are eager to launch our content, and we see a huge opportunity.

Ironically, we're now finding that the integration with the mobile operators technology platforms is becoming the primary bottleneck.

And in a moment, Steve Beason will discuss the solution that we are currently implementing.

Our overall growth is driven by content, but our fundamental hardware system and software technologies continue to be important elements of our portfolio, especially as we intensify our focus on North America.

In this context, we have, as I mentioned, already brought aboard Steve Beason to fill the newly created role of Group CTO.

Many years ago, I had the pleasure of hiring Steve at Scientific Games, having been forced to chase him from one end of Hong Kong to the other until I could finally get him to say yes.

If he has half the impact on us as he had in 10 years at Scientific Games, and before that, GTECH and the Hong Kong Jockey Club, we're in for an exciting ride.

And we think he'll even have more impact on us.

He has unparalleled industry knowledge and extensive experience across the lottery casino, social gaming, horse racing and sports betting verticals.

And so rather than embarrass him any further, I'll ask Steve to say a few words.

Steve?

Thanks, Lorne.

It's really great to be working with all of you once again, and I'm happy to provide a little more color to that nice intro.

As Lorne mentioned, I've been working with the Inspired team for a few months on streamlining our infrastructure to help make the organization more efficient and to really look at monetizing the interactive opportunity.

I have to say that the demand for Inspired's online mobile products really has been incredible, but we're currently limited by the time it takes to integrate with each operator's technology platform.

And a large part of my time has really been trying to spend -- figure out how to increase our effectiveness and to get us integrated with the larger operators, so that we can quickly take our Interactive business to the next level.

After kind of carefully going through and auditing the overall product direction and development and some of the engineering processes we had, we found that we really needed to increase our output levels.

And with most programmers being centralized in the U.K., we were really only getting around a standard 8- or 10-hour workday out of the development group.

But by adding a software development team into India, we were really able to add another 8 to 12 hours of development cycle on a whole different time zone and then thereby effectively increasing the work that gets done in a single day.

And that really is part of our kind of globally distributed software development model that gives us that opportunity for that 24/7 distribution of our resources around the world.

What we did, and in fact we just opened our office in Kochi, India this week, which is up and coming Tier 2 city in India, I have had the experience of running different development centers in India.

I found Kochi to be very attractive from a cost structure, also in terms of salary, cost of living, the cost of commuting and is also very accessible for the rest of us given the international airport access.

But most importantly, Kochi as a city has embraced the tech sector.

The government has started an Infopark, which is where we're actually at.

It's a 100-acre park with over 200 companies in it.

And we're seeing quite a lot of familiar names coming into those offices as well, including places like Microsoft, Nielsen Ratings, Cognizant and even Nissan, where they actually started up their global technology development center.

Towns like Mumbai, Bangalore, Chennai, more of the Tier 1 cities have been at the top of the list for a while, but they're becoming congested and expensive, which is why we, at the end of the day, chose Kochi.

Our first 30 hires that we've got in place will be directly working on things such as integration that I talked about earlier.

And that's really our plan for this team, to start work, and then will expand their capabilities to other areas as we move forward.

Adding software development to the India location really frees up our resources to work on some key strategic initiatives, in particular expanding our business into North America.

Our Interactive, our Virtual Sports and our slots have all really been established well into the European marketplace, but we're looking to add that functionality to our -- to these core products, so that we compete in the lucrative North American marketplace, which happens to be a strong wheelhouse for me.

So I'm looking forward to that opportunity and creating value there.

Well, on that note, I think I'll hit it back over to you.

Thank you, Steve.

Your ability to combine strategic vision with practical problem-solving ability is indeed very unusual, and we're thrilled to have you aboard.

Now let's move on to the topic du jour, the implementation a month ago of the new GBR 2 stake on FOBTs in the U.K. This was a very demanding undertaking for our U.K. team, unexpectedly exacerbated by the accelerated time line from the original implementation date of October.

And they did an amazing job in both the planning and implementation of these changes.

While we are only a month into the process, I think we can say that based upon what we're seeing, we expect the impact to be pretty much in line with our earlier projections.

Interestingly, we're seeing a nice uptick in our Virtual Sports revenues in the U.K. betting shop location.

And in early May, so early on in the second quarter, we've seen positive trends in FOBT revenue in the betting shops following the initial expected declines.

The latter is particularly promising considering that due to the acceleration from October to April, we still have some important product enhancements to deliver to this segment of the marketplace.

So all things being equal, we continue to project the impact of the reduction in the maximum FOBT betting stake on our adjusted EBITDA to be approximately $10 million to $11 million annually on a steady-state basis.

Our projection, I noted the other day, was echoed in the Scientific Games conference call, which makes sense since we have nearly identical market shares in the U.K. But I must admit having had a touch of envy when they characterized this $10 million annual impact amount as being insignificant.

And we remain optimistic about our ability to mitigate a portion of the impact on our operations and financial performance.

Looking ahead, we see sufficient momentum in our other business lines to offset this impact.

We see not only growth in our Virtual Sports and Interactive segments, as discussed above, but we're expecting our first North American VLT placements to begin in the fourth quarter.

We just completed a 2-day demonstration of our North American-centric Valor cabinet and North American game content to a large number of important operators, and we have had very positive feedback.

So we're very excited to get this new product out of the [field].

There's no doubt that the acceleration of the Triennial implementation from October to April will prove to have had an incremental impact on our 2019 financial performance.

We will have had 6 months less time to realize the benefits of our cost mitigation plans and 6 months less time to develop and launch content enhancements.

But we're cautiously optimistic that by the time we get to October, we will have got back to where we would otherwise have been.

And together with the organic growth on our other businesses, we should reach a point of being able to neutralize much, if not all, of the impact.

I'd like now to turn the call over to Stewart to discuss our financials in more detail.

Stewart?

Thank you, Lorne.

Good morning, all.

So overall reported revenue for the first quarter decreased 10.1%.

And it's important, I think, to reiterate some of the factors behind this.

The first is that there was an FX headwind, so the pound to dollar rate in the prior year was $1.40 compared to $1.30 in the current year.

In functional currency to pound sterling terms, the reduction was reduced to about 3.5% or about $1.3 million.

Secondly, as Lorne mentioned, we had $3.6 million nil margin sales in Server Based Gaming in the comparative period.

And finally, also in SBG, we had $1.3 million of nonrepeat software license sales.

So I just want to reiterate that when looking at recurring revenue, there was growth across both segments.

Also as Lorne mentioned, adjusted EBITDA grew 18.5% in the quarter on a functional currency basis compared to the same period last year, but also 28.7% growth compared to the prior quarter.

And about half of the EBITDA increase in the prior year came through gross margin, the remainder from, we call them, above-the-line SG&A costs, which reduced 6.8% in pound terms or 13.3% in dollar terms, as we continue the recent trend of increasing operating leverage by increasing gross margin and reducing costs.

In Virtual Sports, revenue increased 3% in dollar terms and 11% in functional currency, with recurring revenue increasing 17%.

As mentioned previously, there is a drag on revenue growth due to historic license amortization.

In the quarter, we saw strong growth in both the U.K. and Italy and also benefited from a previously unreported revenue in online Virtuals.

And also in the quarter, cost of sales decreased approximately 20% on a functional currency basis.

In Server Based Gaming, revenue reduced 14.8% in dollar terms or 8.5% in pound terms for the reasons I mentioned previously.

Within the quarter, recurring revenue grew 1.1% as growth increase was nearly offset by small reductions in the U.K. as well as, frustratingly, reductions in Italy driven by recent tax increases.

We ended the quarter in SBG with just over 35,000 terminals, up 3,700 from last year.

So if you look further down the income statement, there are increases in the quarter to below-the-line SG&A items, including $1.5 million of cost incurred in relation to the office consolidation in the U.K., which include both people exit cost and owner's lease charges.

There's also an increase in stock-based compensation expense and transaction expenses.

But if you look at kind of more recurring items, depreciation and amortization decreased.

In addition, it is worth pointing out that there was a large swing of about $6 million on the change in fair value of the earnout liability due to stock price movements in the relative quarters, and it's a noncash item, but it did create the net loss in the quarter to $5 million.

But it's important to note that at the end of the quarter, this earnout was settled in stock and no longer represents a liability to the company, and then with it removes the volatility in the P&L.

Turning attention to cash flow.

And I think it's worth spending a little bit of time on this.

So within the quarter, there was net cash generation of $3 million versus $2.4 million in the prior year.

But this is masked by cash flows from financing activities in the prior year predominantly due to increases in levels of revolver drawn.

So if we stripped this out, the current quarter shows a much bigger improvement, $3.2 million in the current year versus an outflow of $0.6 million in the prior year.

So you can do the math then to see an improvement of $3.8 million.

And this improvement is even greater when you remove interest payments, which, in the prior year before the current refinancing, were paid 6 months late.

And in the prior year's quarter, there was no significant payment made in the quarter.

So basically, the improvement of $3.8 million I mentioned above actually increases significantly to an improvement of $7.7 million year-on-year.

And so as mentioned in previous calls, we have spent a significant amount of focus on increasing the cash flows, and it's really good to now see the benefits of not only increased gross margin, but a reduced overhead SG&A costs and also the reduced capital expenditure costs.

And just on that latter point around the capital expenditure, we saw a reduction year-over-year in both tangible equipment at $0.8 million and also software costs, which includes capitalized labor costs at $1.2 million.

And so with that, I'll hand back to Lorne for any additional comments before opening up the call to Q&A.

Thank you, Stewart.

That was an excellent overview of the financial situation.

I don't have any further comments, so operator, if you would like to open the program up to Q&A, please.

(Operator Instructions) Our first question comes from Chad Beynon with Macquarie.

Nice to see some margin improvement and the cost containment.

But I think, largely, you guys are a growth company and that's been the pitch for the past couple of years.

And I know, Lorne, you gave some kind of somewhat facetious goals for Virtuals, but I did kind of want to focus on maybe some near-term opportunities there.

Just because I think this is largely where a lot of the growth and a lot of EBITDA growth can come from in the near term if you execute.

So, a, is -- are we at a much different place than where you thought we would be 2 years ago when this business started to ramp?

And then, b, Steve, you touched on a lot of this in your prepared remarks, do you think you have the right products coming out, the right customer relationships and the right demand to really start getting the growth that we're seeing in the past couple of years?

Well, that's a very complicated question and multifaceted question, Chad.

But I think, in general, absolutely, yes.

As I was saying in my prepared remarks, on the online side of the world, which is the fastest-growing part of the business, right now, we're actually constrained not by the demand for the product, but by the ability to get these integrations done with the customers, a lot of which is -- has been beyond our control, but will get fixed with this -- the effort that Steve Beason described.

One of the issues with the business that is fundamentally a recurring revenue model is that the year-to-year revenue growth rate is somewhat constrained simply because so much of the revenue is multiyear contracts that take a long time to put into place.

But the -- obviously, the offsetting benefit is the revenue is much more secure and much more easy to project.

I think there's -- there have been some areas where we've been slightly disappointed with how quickly the revenues have developed.

Pennsylvania has certainly been one of them.

I think that would be the one area where, I would say, we expected to be at a higher revenue rate than we are.

The interesting thing is that we share these -- the lottery locations in Pennsylvania with Sci Games where they're doing the Keno.

And Keno, which, just across the border in Maryland, is hugely successful, is having the same issues gaining traction in Pennsylvania as we've been having with the Virtual Sports products.

So we're kind of trying to figure out what exactly needs to get fixed there.

I think we have learned in Pennsylvania that there is a fundamental difference between lottery players and sports betting players.

And that the wild, crazy success that we've had in Europe is primarily in retail locations or online operators where we're getting synergistic benefit of being alongside sports betters.

And I think our early product introductions in Pennsylvania were more -- had been more designed with sports betters rather than lottery players in mind.

We're in the process of retooling and changing that.

But again, until the Keno in Pennsylvania begins to show the same kind of performance as it does, let's say, in Maryland or in New York or Connecticut or a number of other states, then the issue is perhaps more endemic to Pennsylvania than it is to anything that we're doing.

So I get that the first quarter revenue growth is not -- might not have been perceived as consistent with the kind of growth that, we believe, is inherent in the business.

Stewart and I explained the recurring revenue growth was 11%, which is not bad for a business model that's based on recurring revenue, but we have a huge number of things that are in the hopper.

The -- I think the -- for everything we're seeing, the introduction of our machine business in North America, which, we think, will begin to generate revenue from in the fourth quarter of this year, is going to be a huge contributor.

And there are a number of things going on in the Interactive part of the business that also are very encouraging.

So I don't think we see the overall landscape or situation any differently now than we might have a couple of years ago.

Actually, if anything, we're probably more enthusiastic, but it's just taking a little bit longer for a number of the initiatives that were predicating that growth on to take hold that, I think, when they take hold, then they'll really take hold.

Okay.

Appreciate it, Lorne.

And then just in terms of guidance, I know you removed annual guidance, I think, last quarter or the quarter before.

But you had given first quarter EBITDA guidance, which you came in squarely in the middle, as you stated, even despite a weakening FX.

Are you willing to give anymore color on near-term guidance?

Or is the reason why you're not just because of some of the uncertainty with the FOBT in the super near-term quarterly...

Yes.

I mean that's exactly right.

The -- I think had the implementation of the Triennial been in October, as it was originally planned, rather than April, as it obviously turned out to be, it would have been a very different story.

But by moving the Triennial from October back to April, it really threw the timing of a lot of things that we're doing out of whack with each other.

And it's just impossible right now to project what, particularly the second and third quarter are going to look like simply because there are so many things going on as we continue with the cost reduction.

It's not clear to us what the -- where the bookmakers thinking is right now in terms of shop closures and so forth that I might ask Brooks Pierce to sort of talk about that in a second.

But I think, by the time we get to the fourth quarter, I think all these cross currents will have sorted themselves out.

And we should be, as I've said in my prepared remarks, pretty much back to where we would otherwise have been.

And with the growth that's happening in a number of our markets, the launch of the business in the States and so forth, I think, as we get to the fourth quarter and move through the fourth quarter, both this $10 million or $11 million annualized, or let's say $2.5 million per quarter run rate impact of the Triennial and, hopefully, at least that much new quarterly EBITDA from our growth initiatives, we can come to a point in the fourth quarter where we're kind of where we want to be.

And I wish I could be more exact about the guidance, Chad, but there's just too many things going on at once in the short term.

But we're big believers in keeping our eyes on the horizon and I think at the horizon, where that horizon is in the fourth quarter, and as we move out of the fourth quarter into 2020, now I think we begin to see quite a clear picture and that picture looks about like what I've described.

Okay.

And then for Brooks, regarding the North American SBG launch in the fourth quarter, I know a lot of market share grabbers in the past couple of years have been successful in their kind of getting up to mid-single-digit market share, and they all started with trials on the floor and then kind of proved that their product could perform at or above the industry norm.

Do you have any indication of interest for trials in North America?

And can you kind of help us think about the perfect type of location or product or place on a floor or really target cabinet area that you're going after in the fourth quarter?

Sure, sure.

Yes, so we -- as Lorne mentioned in his remarks, we had a 2-day session where we literally showed a ton of operators not only the cabinet, which they would've seen at G2E and ICE, but also the content that was developed specifically for the North American market.

And ours, as you know, Chad, is a multi-game terminal.

So the segment that we're going after is the -- what's referred to as the distributed gaming market, so the Illinois of the world, the Oregons, the Canadian provinces where they had G2S, which is where we are with Greece.

And we think that's kind of the sweet spot for us as an opportunity.

So yes, we would expect that we will put games out on trial in the end of the third quarter, beginning of the fourth quarter.

And assuming the performance is as we expect, we would hope to close those deals by the end of the year.

And I can tell you, certainly, in the markets that we've had discussions with the operators, there hasn't been a whole lot of new creative products in that kind of route distributed gaming segment.

So literally, universally, the operators were, a, enthusiastic to see a new product and, certainly, somebody who's had the success that we've had in increased competing with some of the biggest names in the business and getting the success that we've seen, I think the -- there's a pretty warm reception.

So hopefully, the fourth quarter will be the first start.

But 2020, as I've said pretty consistently, is where we think it's going to have a big impact on the business.

(Operator Instructions) Our next question comes from Mike Malouf with Craig-Hallum.

If we could just -- a little follow-up on the previous question.

I'm wondering if you could flesh out a little bit more about how big you think the market is, the targeted market that you're looking at.

And I mean as you look out 1 year, 1.5 years from now, what would you judge success based on sort of the preliminary indications that you're getting?

Well, I mean, I think if you look at Eilers reports, you can see what the addressable market is across all the Canadian provinces, Oregon, Illinois, West Virginia, Montana, Nevada, that'll give you the size of the market.

And I know Eilers also talked about the replacement cycle in those markets.

Interestingly, in Illinois, a big part of the conversation with the operators there is the view and the hope with changes that, possibly, Chicago could come on as well, which would be a huge boost to the addressable market.

But I think, for us, in terms of success, clearly, we need to get the product out there.

And it's -- one of the good things about this business is if your product performs, you'll have plenty of customers that want to take it.

And we feel pretty confident based on our track record in other markets of being able to do that.

So I don't think we give outlook to [Amy or Borne].

And I don't think we give specific numbers as to what we're looking for at this point.

But I would think that, as Chad kind of alluded to, we would consider ourselves to be kind of in that category of market share grabbers.

And just remember, in terms of the markets we're going after, really, the kind of -- it's really Sci Games and IGT dominate that segment.

So the competition is not like where you would see on a normal plaster you can see on a floor where there's the big 4, plus all others.

Okay.

Great.

And then if I could just dive down a little bit into Virtuals, specifically into Pennsylvania.

Just trying to get a sense of maybe more specifically where you are with that opportunity and in some of the other Virtual opportunities here in the U.S.

Sure.

Yes, so Pennsylvania, probably, the next big thing that will be happening in Pennsylvania is that we'll be launching our horseracing product, which we've done a bunch of customer-focus group work.

And it was, by far, not even close, was the event that resonated most with lottery players.

It's the one that they recognized, one that they understood and one that they understood to be a betting proposition, whereas our American Football, as we call it, game was not really in that.

And then there's a couple other kind of big factors that changed.

When we initially set this up with Pennsylvania, the maximum prize that you could have in our -- either our football product or the car racing product was $250.

And the horse racing product with Pennsylvania where we will have a multiplier, which is something we haven't had in the past, the maximum award will be $800,000.

So you can see that's a pretty dramatic difference between what -- from a player experience.

It's a product that they know very well from horseracing.

It's very easy to figure out.

It's static odds, a 12-horse race.

And then adding multipliers and putting together a betting pattern of some of the longer shots gives you the opportunity to win up to $800,000.

So -- and I think there's a renewed commitment from the Pennsylvania Lottery to promote and support this because, as Lorne mentioned, in both Keno sales and, quite frankly, in our sales, so the whole monitor games business to this point hasn't been as successful as either Pennsylvania Lottery or ourselves or, I'm sure, quite frankly, Sci Games would have liked.

But we feel pretty encouraged about the new product that's potentially going to be launched, I'd say, in the fall just to make it -- maybe late summer, early fall is probably the right time to think about it.

So we're hoping that, that's going to move the needle pretty dramatically in Pennsylvania.

Just in terms of other Virtuals in North America, for example, we'll be going live in June in New Jersey online with bet365 who, as you know, is the largest online gaming and our largest customer on the Interactive side for Virtuals, where they'll be introducing 17 streams of Virtual products online to the North American market.

So we're very excited.

Again, as you probably would've seen in New Jersey, some of the non-operators i.e., the FanDuels and DraftKings, have gotten the lion's share of the sports betting market.

And we're pretty sure that bet365 will be successful and certainly successful with our Virtuals product.

Probably one other thing, it's not U.S. that we didn't mention that's turned out to be, I think, kind of surprisingly, a very successful and lucrative market for us is in Morocco where we have a partnership with Intralot on the lottery side.

And the numbers that we're seeing out of Morocco on a smaller scale than the total market size in both Italy and Greece on a per shot basis, believe it or not, Morocco is the highest-performing Virtuals market in the world.

So I think kind of a little bit to Chad's question, I think we see a number of opportunities to grow the business, as Lorne talked about, really across all segments.

This concludes our question-and-answer session.

I would like to turn the conference back over to Lorne Weil for any closing remarks.

Thank you, operator.

Thank you, everyone, for calling in this morning.

We appreciate your support.

We continue to be very enthusiastic and optimistic about where the business is heading.

We need to get through the next couple of quarters to fully digest the Triennial thing.

But with everything that's going on in the company, we're quite positive about where we will be by the end of this year and as we move into 2020.

So thanks again, and we'll speak to you next quarter.

The conference has now concluded.

Thank you for attending today's presentation, and you may now disconnect.