Paradox Interactive AB (publ)

STO:PDX

Earnings Call Transcript 2023-Q1

[Alex Bricca, CFO]

Hello, everyone, and welcome to the Paradox Q1 2023 Quarterly Report stream. I'm Alex Bricca, I'm the CFO of the company. And I am today alone in the studio, but with me nevertheless, I have Fred, our CEO. How are you doing, Fred?

[Fred Wester, CEO]

I'm doing really well. And it's always great to be with you even if it's on link, and it's always great to present our reports even if both you and I are in agreement that we probably can do better than this and the people should expect more. But let's go with what we have for this quarter. So we can take the next slide. That's me. So we see this as a warm up to a very exciting and challenging year. We have already announced a range of titles, Lamplighters League, Life by You, and the Cities: Skylines II. They are going to come later on this year. And we have gotten really, really good reception of the game so far. A lot of people expect a lot from us. And we like that. We also have a strong lineup of upcoming DLCs. As you can see in May, we have a really full May with releases almost every week, including a release from Paradox Arc there as well. If you summarize this quarter, you can say that we're somehow happy with the top line, but it's a very unexciting bottom line. It's due to normal release volatility, of course, I mean, we're comparing to a quarter that is fairly strong. We had last year, the first big DLC for Crusader Kings III released Royal Court. And this year, we didn't have a big DLCs per se. Some amortizations and write-downs as well of projects that [hasn't] worked so well.

We've been blessed to have no write-offs in the last 12 months, what we had in this quarter. So it's obviously hitting the bottom line. The multiactive users for this period is very steadily at the upper 5 million to 6 million range. So we're really looking forward to when we can say that we, in a stable way, have more than 6 million monthly active users. It's going to happen sooner or later, we'll see exactly when that happens. So we'll move on to the next slide, oh, there you go. As you can see here, not a lot of releases, just Stellaris: First Contact. And one Console release for Stellaris as well overload. We did a remaster of Cities: Skylines and a couple of minor DLCs, rebirth for Surviving the Aftermath and Jungle Pack for Prison Architect was the major releases that we had in this quarter. So a fairly soft release quarter for us, as I've said before. Paradox Arc released Surviving the Abyss and Knights of Pen and Paper, who unfortunately did not perform as well as we hoped. And maybe those were games that were in the portfolio 1.5 years ago when we did a big kind of evaluation of all the titles and closed games for more than SEK130 million, and maybe these games should have been closed as well at that time. But with the new depreciation model as well, it hits very hard this quarter and then it's basically done. So we have a very clean balance sheet going forward. Across the Obelisk is doing really well.

We announced and released the first DLC workforce, and we're looking forward to having this game follow us for many years to come. Hopefully, the coming five to 10 years period, we're going to see a lot of releases for this franchise as well. Game announcements in the quarter, it's a bit more there. A couple of heavy heaters. We have Cities: Skylines II, which is obviously the sequel to our best-selling game of all time. Life By You, life simulator, developed by our development team in Berkeley in California. Age of Wonders 4 that is releasing on Tuesday next week, it's a brilliant game. I think you should all play it. If you don't like it, I'll make sure to refund you personally. I guarantee it. And we have the Lamplighters League developed by Harebrained Schemes in Seattle. And of course, we announced also Mechabellum from Paradox Arc that you can see down there, and it's going to release also in May. Like I said, May, it's going to be busy. So don't book anything, don't plan anything. It's full of games and DLCs from Paradox. And after the quarter, what has happened, we've been busy actually with Europa Universalis IV domination being released and quite well received as well. We announced Stellaris: Galactic Paragon, which is going to be released, you know it, in May. Victoria 3: Voice of the People announced as well. First DLC for Victoria 3 is going to be released in May. Crusader Kings III: Tours & Tournaments got a release date and it's like I said before, it's in May. And the same goals also for Cities: Skylines Hotels & Retreats, which we announced today actually. So May is looking super exciting, to be honest.

And not only in a gaming perspective because we're also going to invite you to the first Paradox deep dive, as we call it, where we present the company. It's a capital event. It's taking place in Stockholm on May 23. I'm going to be presenting. I think Alex is going to be presenting, a couple of other people from Paradox because you see me and Alex a lot, but you don't always see the people who actually make the games or make the games happen. They're going to be there as well. So we're going to present how we make games, how we see the future and what you can expect from Paradox in the coming couple of years. So it's going to be really exciting to meet you all. Alex, are we going to live stream the event?

[Alex Bricca, CFO]

Yes, we are. So everyone is invited, existing shareholders, potential new shareholders, everyone else.

[Fred Wester, CEO]

Fantastic. So we're going to live stream the event like Alex said, perfect. We're going to send you a link well in beforehand, which takes me to Alex. So your turn, Alex, just fire away.

[Alex Bricca, CFO]

Thanks, Fred. So numbers. Fred already mentioned that we are rather pleased with the top line. So it lands at SEK483 million. It's almost the same as Q1 of last year where we did SEK476 million, so it's actually 1% more. As always, what drives revenue for us is what we released in the quarter, but also a currency impact. compared to Q1 last year, the currency movement has been beneficial for us. I think the dollar is up some 12%, euro 7% and pound, roughly 1%. And we have some 97% of our revenues in other currencies than SEKso when the foreign currency goes up, our revenue goes up as well, and that has happened in Q1. But more importantly, the currency movement is what we released in the quarter. And we have not -- we have released quite a lot of DLCs in the quarter, I think. But it hasn't been on our major core franchise, and that -- there is where we make the revenue. So we released -- Fred mentioned them, but what drove most revenue, I would say, are the smaller releases on Cities: Skylines, the content creator packs and radio packs. And of course, the story pack that we released on Stellaris. Then we did several releases on Surviving the Aftermath, Stellaris: Console, Prison Architect and small music pack for Victoria 3 as well but they tend to not drive that much revenue. And again, to repeat a bit what Fred said, Q1 last year was great because we released a proper DLC for Cities: Skylines and our first, I think, ever $30 DLC or expansion for Crusader Kings III. So very strong sales and revenues one year ago.

So we have had less releases this quarter. And despite of that, I would say, quite a lot of revenues. We had something called Steam Spring Sale this year. Previous years, we have had Steam Lunar sales a month earlier, but both in Q1. So I think those are fairly equal to each other. Top 5 revenue contributors. I'm sure most of you can guess them, Cities: Skylines, Crusader Kings III, Stellaris, Hearts of Iron IV and Victoria 3. Out of them, Cities: Skylines has been doing very well. And it's not a coincidence. Cities: Skylines has released something in terms of content, all of the last 3 quarters. And that -- we always repeat and say that it's what we released in the quarter that drives the revenue, but it's also what we released in the quarter before because coming out with the constant releases, keeps the player attention, the player activity and the player spending up. And Cities: Skylines is a clear example of that in this quarter. Our other bigger franchises, only Stellaris that came out with DLC this quarter. And I think in Q4, none of the Grand Strategy franchises came out with any content, except for the full release of Victoria 3, of course. But as Fred showed next quarter or this quarter, the second quarter of the year is considerably more busy in terms of ground strategy game releases, which we look very much forward to.

Operating profit came in at SEK156 million. That's a 25% decrease compared to the SEK209 million we had last year. And if revenues went up 1% and profit down 25%, obviously, costs have increased, and we're going to go through that shortly. Profit after financial items or profit before tax, SEK157 million this Q1 compared to SEK208 million Q1 of last year. And profit after tax came in at SEK124 million compared to SEK187 million a year ago. And the profit margin is down from last year's 44% or last year's Q1 of 44% to 33% this year. And the main -- two main reasons to lower margin, we have released less content on our core franchises. Those are our high-margin products. So that is where we make high-margin revenues. And we have also had a couple of items under cost of goods sold that are kind of one-offs coinciding in one quarter, which we will shortly come back to. Equity through asset ratio increases to 75%. We have a very solid balance sheet. Number of employees end of March, 674 compared to 692 same quarter last year or 656 end of year last year. So during the first quarter of this year, we have increased staff with 18, and that is all in our Swedish studio. Our foreign studios and our publishing business has stayed flat, but we have increased in our development teams in Sweden. So let's move to the next slide and go through a special costs of the quarter.

This slide shows in green, our revenue, where you can see that it fluctuates quite a lot between the quarters, even though it's upward driving trend. And then we have our three main cost items in yellow, blue and red or perhaps it's more orange than yellow. Red and blue administrative expenses and selling expenses, those you can see, have been fairly flat from quarter-to-quarter. And administrative expenses should be -- they are stable. But selling expenses, selling expense has actually gone up from SEK42 million Q1 of last year to SEK48 million Q1 this year. And that has to do with us being more active in the selling -- with the selling activities. We have announced quite a lot of games in Q1 and started to market them. So paid marketing and different activities for not the least Age of Wonders that we are releasing next week, Age of Wonders 4. So let's move then to cost of goods sold, which is our largest cost item. So this includes cost, all our development costs, regardless whether we take them, expand them directly or whether we capitalize them and amortize them. It includes royalties that we pay to external studios, if we do that. It includes amortization on acquired assets, and it includes tech staff that works in our publishing business as well.

So by far, our largest cost item. So all in all, SEK263 million in Q1 this year compared to SEK215 million in Q1 one year ago. So it's an increase of SEK48 million. And it doesn't say here, but if you watched our latest stream for Q4, then you might remember that in Q4, we had cost of goods sold for SEK253 million. So we are up SEK10 million compared to a quarter ago. Let's dig in a bit to where the movements lie. As Fred mentioned, we took -- we actually canceled a capitalized development project in Q1. It's the first time we do that since Q4 2021. So first time in a little more than a year that we have a write-off. We used to have these, I would say, three out of four quarters before, and it used to be, in the year, 6%, 7%, 8% of our capitalized development, that is what we used to write off due to cancellations every year. But when Fred came back 1.5 years ago, we did a major review of our ongoing projects and decided to terminate several projects where we deemed the risk reward ratio be too low. So that led to us writing off, I think it was SEK135 million in Q3 2021. So we cleaned up a lot, which has had a big impact with no write-offs in 4 quarters, but we also changed the approach to how we invest in high-risk projects. So where we invest much less money during the early high-risk phases and where we don't capitalize.

So both those two reasons or both those two facts are reasons why we have seen so much less write-offs. But once in a while, I'm sure they will continue to come. So we had SEK10 million this quarter. Also under COGS, we have amortization of our game development or our developed games, we capitalize in the development phase and then we amortize them over 18 months. So SEK110 million, it doesn't say here, but if you read our report, you will find a number, SEK110 million of amortizations in Q1 compared to SEK82 million of amortizations in Q1 last year and SEK119 million in amortizations in Q4 last year. So compared to Q4, we have decreased amortizations with SEK9 million. And let's hang on to that a bit and figure out where the movements are. There are mainly three things that has moved compared to Q4. One is Victoria 3. Victoria 3 released in Q4. So we had -- it released in October. So with our degressive amortization method, we amortized and took us cost 46% of the capitalized development in Q4, quite a lot. In Q1, we are still in a fairly high amortization period. So we amortized some 20% of the development costs, still quite a lot, but less than half of what we did in Q4. So that brings down the amortizations. But then we released a new game. We released Surviving the Abyss. It was released under our publishing brand, Arc. But this is a game that we started some 3 years ago under our, at that point only, publishing business with our old development approach. So that meant that we capitalized the game from the start.

We used an external studio and that has been going on for three years. So after three years, it's not an unsignificant amount of money spent on the project, and we released it in January, applying our usual degressive amortization method means that in Q1, we took 46% of those development costs as cost in Q1. So that increases the amortization in Q1 significantly. Then we had another kind of a special project. We -- perhaps you noticed together with two partners, we released Stellaris on VR. So this is a collaboration we have with Oculus and the Fast Travel Games. And we think this is -- VR is not, by any way, our core platform. But we think this is a cost and resource efficient way to test out our franchises on new platforms. So either we can find the new players perhaps or we can add some value to our existing players. So this ends up as an increased revenue on our side because we have got funding for this project, but all that funding is passed through to the company, Fast Travel Games, developing the game. So even though the development has been going on for a while, the game was released this quarter. So that meant that we recognize both the revenue and the costs this quarter, and the costs were recognized through an amortization. So that also pushed up the amortization this quarter as a single event, you could call it.

[Fred Wester, CEO]

Yes. We have seen it more as a branding event for the game with potential upside if it brings in more royalties.

[Alex Bricca, CFO]

Yes, that's right. Depending on what the -- how the game sells, we are getting nice license royalties on that one. And I've only noticed that the game has quite good ratings on Oculus. So if you're into VR, try it. More on the COGS. So we have SEK22 million as amortization for acquired businesses and assets. So -- and that's fairly much the same as last year. I think last year, it was -- I think it was exactly SEK22 million as well. So it means that we take almost [SEK90 million] every year where we amortize the assets and the businesses that we have acquired over the years. So it's Harebrained Schemes, it's World of Darkness. It's Playrion. It's Prison Architect, Triumph. So instead of keeping them on the balance sheet at acquired value, we choose to amortize them over the years. So it decreases our balance sheet, but it also has a decreasing effect on our profit for now. More under -- then we have other amortizations during COGS for offices. And with the IFRS 16, where we put up the rent agreement as an asset and amortize it. That is also included in the cost of goods sold here, the part of the rent that refers to our studios, which is a majority. Then we have kind of the final item under COGS is royalties, tech costs in the publishing organization and noncapitalized development cost. That adds up to SEK113 million in Q1 this year compared to SEK104 million of the same quarter of 2022. Royalties came in at SEK29 million for Q1 this year, almost identical as one year ago, and royalties for us is mainly on Cities and Across the Obelisk.

And when we release stuff on Cities, we get high revenues on Cities and then also the royalties fairly comes up. Noncapitalized development costs and the tech cost in the publishing came in at SEK83 million compared to SEK75 million one year ago and also SEK73 million in Q4 of 2022. So we have increased these kind of tech costs that we take as immediate cost with some SEK10 million compared to Q4. And here, for example, are all the games that we develop that we deem are too risky to capitalize. So everything that our new games team does is included here. I think we're done with this slide. Now, we have a row at the bottom of the table to the right. Other income and expenses that is most -- mainly FX movements during the quarter. So it's positive, which means that especially the dollar should have gone up during the quarter. It for sure did in Q1 last year. Q1 this year, it has been fairly flat, so it shouldn't go up this March, and it hasn't. And the reason why the item is still at almost SEK7 million is because there is another item that is included here. And at this, our share of the profit from our minority holding Hardsuit Labs in Seattle. So it's not only our share of the Q1 profit for this year, but it's actually a big chunk of last year's profit that studio did that ends up here. Now we can move on to the next slide.

So these are the same revenue and operating profits that you have seen, but showed over a larger time period. And there, you can see two things, I think. One is that both profit and revenues is, over time, trending upwards. The other thing that you can see is that the quarters are very volatile. If you look at single quarters, it can go up and go down. If you look at some certain isolated periods like Q1 to Q4 last year or even other years, it can look like there is a stability between the quarters, and it was. But that, I would say, to guide a bit for the future, which we always tend to say is that it's more likely that the future is going to continue to be volatile than stable in terms, but we aim to keep it growing. And I think that shows a bit better on the next -- on this chart. Here, we have grouped 4 months together, and there the volatility between the quarters becomes less evident. And then the trend over time becomes more visible. And here is quite clear that we have a very nice and stable up trend -- upgoing trend in terms of both revenue and profit. So that's...

[Fred Wester, CEO]

And that's good, to be honest.

[Alex Bricca, CFO]

Let's continue like that. What you say…

[Fred Wester, CEO]

Let's keep it that way.

[Alex Bricca, CFO]

All right. Cash flow, very strong. Cash flow from our operating activities, SEK245 million came in during the quarter. We invested SEK869 million of that into game development, -- if we look at the last four quarters, we have more than SEK1 billion, yes, SEK1.94 billion in positive cash flow from our operations, whereof we invested SEK806 million in game development. So we have been in a very high investment phase for quite some time, as you can see, it goes three, four years back with very high investments. We will continue to invest quite a lot. But as our announcement have shown, we're also now going into a period where we finally are going to start releasing quite a lot of the games that we have been working on for quite some time, but we are very excited about that. Yes. I think this is the final slide. So equity and noncurrent assets. Our equity is a little more than SEK2.4 billion. And out of those SEK2.4 billion, more than SEK2.3 billion comes from our historical profits minus what we have paid in dividends. So pretty much everything of our equity comes through our own operations, which we are very proud of. Yes. I think that is what I had planned to go through. I know that we have already got in some questions.

[Fred Wester, CEO]

Yes.

[Alex Bricca, CFO]

Let's see what we have.

[Fred Wester, CEO]

Let's see the questions here.

[Alex Bricca, CFO]

I have one for you, Fred here, I think.

[Fred Wester, CEO]

Yes. Cool.

[Alex Bricca, CFO]

In which way are you planning to use AI at Paradox? Are there any use cases at the moment? And how do you think AI will change game development? Very topical.

[Fred Wester, CEO]

It's a very broad question -- both broad and not. I mean, first and foremost, I've never seen a technology that is going to change our industry so much as AI in general, and I'm talking about AI generating graphics, AI generating techs and AI helping or even generating cold in different aspects. And I think it's going to be very useful for us. People ask about if it's going to be a job cutting thing, I don't think so. I think that it's going to help us be much more efficient. It's going to help us do things faster and with higher quality. So we see it more as a tool for efficiency internally and to be able to deliver things faster. We are working with AI in all our departments of Paradox, everything from marketing to the development studios, with the graphics, with the colors, with the game designers. So yes, we are, hopefully, in the forefront when it comes to using AI to help us get better as a game studio. Next one is for you, Alex. So how much on the amortization of capitalized development costs is related to new games?

[Alex Bricca, CFO]

Right. Yes. So we went through the cost of goods sold. And I said that SEK110 million of the cost of goods sold in Q1 came from amortizations. It's not -- we don't share, or we don't split that up more in detail what it regards to. But I can say this much for this time then, roughly half -- roughly 50% of those SEK110 million regards amortizations of new games in this quarter. So that would be what I would call new games in this quarter would be still Victoria 3, where we have still a significant amortization in the quarter, Surviving the Abyss where we took 46% in the quarter. But also what ends up as a new game here is the Stellaris VR project. Yes. So roughly 50% this quarter, but it will swing back and forth depending on how much new games we release, of course.

[Fred Wester, CEO]

Yes.

[Alex Bricca, CFO]

Fred, how do you weigh and plan quality improvement of games already released in terms of free update versus working on new content, which will generate sales income?

[Fred Wester, CEO]

Well, this is pretty much up to partly each to the side, but also so that we can remain stable and profitable, so -- which we need to enable to -- in order to both grow and create better games and better services for our gamers. So -- and we're fairly happy at the moment with the mix we have in between precontent and paid for DLCs. What we would like to increase is the velocity of which we release content. So we will release more free content and more paid for content more often than before, if possible. So I would say the answer is a little bit of everything, to be honest, maybe a bad answer. But I can't give you a better answer on that at the moment. But I hope it gives some direction at least. Alex, what will the impact be on the development of Stellaris due to the Swedish studio consolidation, they're thinking about Malmö and Umeå studios, I guess.

[Alex Bricca, CFO]

Yes, for sure. Yes. So our Umeå studio Arctic has been helping our Studio Green as we call the part of the Stockholm studio that is responsible for Stellaris. So I believe in the long term, the reason why we have done this is to improve the productivity and efficiency of the game development. So in the long run, I think this will increase our ability to deliver content. So it should improve it. Here and now, the impact is very limited. So the affected studio, Studio Green, have a very solid plan in place how to handle this short-term effect of the change.

[Fred Wester, CEO]

Yes. Sounds good.

[Alex Bricca, CFO]

Question to you, Fred. How do you decide on how frequent DLCs should be for a single game? And also, why does some have more smaller DLCs and some just one big DLC per year?

[Fred Wester, CEO]

It's a bit related to the former question, but you could say generally that it's part of the development team, but it's also up to like the games. So the games are a bit different in the player needs and what the development path is for the game. So it depends a bit on that. It's also part of how old is the game, how much can we do for the game, et cetera, et cetera. But that means that some games are better suited for smaller DLCs with more limited scope and others have a bigger scope with more like system changes depending, like I said before, like on what the player base likes as well. So when it comes to release frequency specifically, we know like I said before, that people want both large and small DLCs and we've done surveys on that, then we are able to deliver at the moment. So that's why we're also focusing on getting the speed up in delivering more content. And as I said, they're for both free content and paid for content [already]. Alex, how do you view acquisitions and how many potential acquisitions do you look at in a year? Is the idea acquiring within the management segment or complete a new vertical where you look at acquisitions or only recruiting talent in case of a possible acquisition?

[Alex Bricca, CFO]

That's a long question. And I think we get this M&A questions on every quarterly stream. So evidently, there is some requests out there to perhaps acquire more. But as we say, we have always been a company with an industrial view and focusing on organic growth. Looking historically, we have acquired what we call production resources. So it has been either skilled new colleagues that can help us develop the games that we want to publish over the next years or it has been intellectual properties that we can use to make new games. And looking forward, I think those are the most likely acquisitions that we could end up with. But we are also being opportunistic. So if something more game-changing comes up where we think it has a perfect strategic fit and it's a good price, we are looking at those acquisitions as well. Fred, with the proposed closure of Arctic and Thalassic, what's the thought process going ahead on any potential new studio openings?

[Fred Wester, CEO]

Well, these studios, we are looking to close to focus the development to Stockholm in Sweden due to efficiency reasons mainly. But both in Sweden and internationally, we will continue to act in a more opportunistic way. If you see any opportunity arise, we might grab it. And that's how we started, for example, Paradox Tectonic in Berkeley. And Alex had a question about M&A, and we're going to look at that type of things as well. But as always, we're not in a hurry. So our task is, first and foremost, to make great games and serve those great games, which we do at the moment. And opportunities will arise, especially in a market like this. It's a more volatile market, even if we don't feel it too much. So new studio openings sure, but it's not going to be our primary focus. It might happen, but it's because you see it as the right fit for us at the moment. Okay. Alex, other revenue of SEK17.7 million, can you describe what's included and why it's still volatile?

[Alex Bricca, CFO]

Yes. So this other revenue. This must refer to one of the notes in our quarterly report, where we split our revenues between PC, console, mobile and other. And other is suddenly significantly higher. So what often is on other revenue is licensing. And why it's so high this month is due to this collaboration regarding Stellaris VR, I just mentioned. So we have a collaboration with Oculus and Fast Travel Games. So we ended up with a significant amount of revenue, but also with the equal amount of amortizations. Fred?

[Fred Wester, CEO]

Yes.

[Alex Bricca, CFO]

A financial question. There is a significant tilt in Q1 from CapEx to OpEx. Is that random or what's the reason for that?

[Fred Wester, CEO]

I got a financial question. Let's see if we can do this. But it's a fairly simple answer really. And there is a tilt, yes. And it's because we generally take project costs earlier on when we started. We take it on an ongoing basis, more than adding it to the balance sheet, especially if you look at everything that the new games team is doing, it's operational. So we take it directly as a cost rather than adding it as CapEx. So that's the simple answer. Alex, where does the revenues from Epic go in the geographical distribution? That's a very specific question, but I like it.

[Alex Bricca, CFO]

Yes. And it has a very specific answer, North America. So again, this refers to one of our notes in the quarterly report, where we divide all the revenues in geographies. And what we should be aware of there is, this is divided based on where the distributor is located. So regardless of where the player sits, since the distributor Epic is located in the U.S., all the revenues that comes through Epic ends up as North American revenues.

[Fred Wester, CEO]

Fantastic, and that's it, right, for this time.

[Alex Bricca, CFO]

Yes Done. No more questions. So what's coming up? You mentioned it, Fred. We have 23rd of May, we're going to stream our deep dive in Paradox.

[Fred Wester, CEO]

Yes.

[Alex Bricca, CFO]

And our colleagues, of course, have many streams in between that. But then our next quarterly stream is in end of July, I think it's the 27th of July, where we present our second quarter.

[Fred Wester, CEO]

Indeed it is. And our next big release is Age of Wonders 4 on Tuesday next week, and I already promised to, what you call it, to pay back if people aren't happy with it to do that personally. So I have to stand behind that because it's a great game, and I hope you all play it. So I got that said as well.

[Alex Bricca, CFO]

Great.

[Fred Wester, CEO]

And I think it's a great way to -- yes, that's a great way to finish this stream and looking forward to see you again when we present Q2. Take care. Cheers.

[Alex Bricca, CFO]

Thank you very much for watching. Take care. Bye.