What’s Behind Glu Mobile’s 150% Gain?

Although it’s far beneath Wall Street’s radar, Glu Mobile (NASDAQ: GLUU) stock has quietly had an amazing year. On a year-over-year basis, shares of the mobile app game developer have advanced 120% versus 19% for the Russell 2000 small-cap index. Still, it would be a folly to call Glu Mobile’s public-market performance a success. Shares are down 45% since its 2007 IPO, while the index has increased 140%.

However, the market is a forward-looking mechanism, and past performance should only be utilized in the context of whether it is predictive of a company’s prospects. Investors should ask whether Glu Mobile’s future resembles its performance over the prior year, or whether it’s the same company that has significantly underperformed the market since its IPO.

Glu Mobile is growing revenue, but consistency is key

At first glance, Glu Mobile’s financials appear to support its incredible stock run. In fiscal 2017, the company grew revenue 43% over the prior year on the back of successful releases Design Home in late 2016 and MLB Tap Sports Baseball in 2017.

In three of the last four years, the company has reliably grown both revenue and gross profit, so it’s prudent to ask what went wrong in 2016. Launches during the year — Katy Perry Pop, Kendall and Kylie, and Nicki Minaj: The Empire, among others — were unable to create the same demand as the prior year’s launches, most notably Kim Kardashian: Hollywood. This year’s revenue growth was impressive, but it’s unclear if consistency is attainable going forward.

Profit margins going in the wrong direction

One thing Glu Mobile investors should continue to watch is profit margins. Although 2016 was impacted by a one-time event (a royalty payment to Tencent for Glu’s Rival Fire game), making the 83% year-over-year growth figure slightly misleading, Glu Mobile has seen its gross margin figures deteriorate in recent years as the company blames higher fees from digital storefronts like Apple‘s iOS and Alphabet‘s Android.

Glu Mobile 2013 2014 2015 2016 2017
Revenue $106 $223 $250 $201 $287
Cost of revenue $37 $86 $108 $120 $141
Gross profit $69 $137 $142 $80 $146
Gross profit margin 65% 61% 57% 40% 51%
Total operating expenses $90 $135 $147 $160 $231
Operating income ($21) $2 ($5) ($80) ($86)

Source: Glu Mobile’s 10Ks. All figures in millions except percentages.

Although the company has mostly produced negative operating income over the last four years, this has figure has precipitously increased due to larger growth in operating expenses. As a comparison, Glu Mobile’s revenue increased approximately 15% while its operating expenses increased 57%, mostly due to a large increase in sales and marketing expenses.

Is Glu Mobile “buying users”?

Glu Mobile’s business model is two-fold: Create new titles to drive free downloads, then monetize the titles over an extended time frame by microtransactions — low-priced, in-app purchases that allow players to play longer, acquire game advantages, or accelerate game progress.

Lower profit margins are noteworthy in light of the company’s business model of developing evergreen content, strong titles that can be slightly revamped to capture long-tailed revenue. This should result in higher margin profiles as revenue increases. As my colleague Harsh Chauhan notes, a lower margin profile with substantive top-line growth is indicative of buying users, spending large sums of money to acquire growth at the expense of profits.

High-risk watchlist candidate

Glu Mobile’s recent run was mostly due to easy year-over-year comparisons, as fiscal 2016 was relatively poor on a revenue and gross profit basis. However, that doesn’t mean the company is not improving its top line, as the company is no longer dependent on a single title (Kim Kardashian: Hollywood) and bookings continue to rise. Still, I need more than a single year before I’m convinced.

This is still not a stock for the faint of heart. It’s clear the company’s margins are going the wrong way as operating expenses have increased at a faster clip than revenue over the last two years, although CEO Nick Earl appears to point to margin improvement in future quarters. High-risk investors should keep the stock on their watchlist and watch margins carefully. Until the company can prove this year’s strong revenue growth wasn’t a one-off or improve its gross-margin profile, I’d stay clear of the name.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Jamal Carnette, CFA owns shares of Alphabet (C shares) and Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Tencent Holdings. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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