Fractal Gaming Group AB (publ) (FRACTL) Earnings Call Transcript & Summary

Welcome to the Fractal Gaming Group Q2 2023 Report Presentation. [Operator Instructions] Now I will hand the conference over to the speakers CEO, Hannes Wallin; and CFO, Karin Ingemarson. Please go ahead.

Hello, everyone, and welcome to today's presentation of our Q2 report. We're going to walk you through the latest developments in our company and industry to share and discuss all the relevant details of our report. We will start with some highlights from Q2. Our sales increased by a staggering 157% year-over-year measured in Swedish krona and increased by 139% measured in U.S. dollars. This means that our revenue increased by more than 2.5x. We are, of course, incredibly happy and proud of this development, and we will explain more in detail in this presentation about the specific dynamics of our revenue development. Sales out revenue increased by 49% year-over-year, which is a testament to the very strong demand for our products. The difference in revenue increase, which was 139% in U.S. dollars, and sales out increase is explained by channel stock filling dynamics, where our sales channel partners needed to also increase their stock levels to match the higher run rates. We now believe that the stock filling is completed for now and that revenue in coming quarters will be more in tune with our sales out. Our market share has increased significantly in the quarter, which was driven by a very successful product releases but also from our expanded efforts in sales and marketing. The market overall is back to a healthy growth, but it's clear that we're growing much faster than the markets. In the quarter, we launched a new case called Terra with a very positive market reception, further establishing our design-first driven product strategy. EBITDA increased to SEK 48 million compared to minus SEK 3 million a year ago. Our product margin has improved significantly year-over-year to 40.2% compared with 30.7% last year, primarily driven by a positive impact from shipping rates coming back to normal. The overall PC market has been declining for several quarters, but the PC gaming part of it is remaining strong and is now back to growth. During the pandemic in 2020 and 2021, there was a surge of new gamers and upgrades, and it is expected that those consumers who need to upgrade sometime between 2023 and 2025, further driving growth. Starting in Q2 and leading into Q3 and Q4, we see several strong games releases, the most note worthy being Diablo 4, Baldur's Gate 3 and Counter Strike 2 and new games content is an important driver for the general gaming interests and consequently hardware upgrades. The new data released from Newzoo, we can see that more than 50% of gamers and viewers of gaming are discovering new brands while engaging with gaming. Also 42% the gamers say that they bought a product or service recommended or used by their favorite streamer, which leads us into our next slide, where we're going to talk a bit about the launch of the Fractal creator program in Q2. So, Fractal has partnered with more than 150 streamers to be able to engage with the fast-growing gaming streaming community. We have decided to target small to medium sized creators and started work with a large number of them. We have seen that small to mid-sized streamers are typically having a more engaged and tight-knit community with higher engagement per viewer than the bigger streamers. We strongly believe that this initiative will help us to reach new audiences and further strengthen our brand and position. As briefly mentioned before, we launched a case called Terra during Q2. Terra is a smaller form factor case, a format that is quickly gaining ground. The striking yet elegant design of the Terra using premium materials such as aluminum and real wood is yet another testament to the success of Fractal's unique design-driven product strategy. The reception from the market has been extraordinarily positive and the product quickly sold out in major markets. Leaving over to you, Karin.

Thank you very much. Net sales in the second quarter was the strongest in Fractal's history, both in Swedish krona and in U.S. dollar. Net sales increased by 157% to SEK 245 million. All our sales are in U.S. dollar regardless of the end market, and the organic increase was 139% and amounted to $23 million. The U.S. dollar, SEK rate was 10.5 in the second quarter compared to 9.8 in the same period last year. The strong net sales growth can mainly be explained by strong demand for Fractal's products. We have made several successful product launches in the past 2 years, and we now have the strongest product portfolio ever, which has contributed to increased sales. Case series as North, Pulp and Torrent were among the best-selling products during the second quarter. As Hannes mentioned earlier, a clear proof of the successful releases is that we have taken market shares. The low levels of stock in the sales channels is another explanation for the net sales growth. The increased demand from end customers has led to retailers replenishing their stock to be able to meet the increased sales growth. We believe that the stock buildup at our retailers is now at healthy levels and that the net sales in the coming quarters likely will be at the same level as sales out. Good access to graphics cards and new GPUs on the market are also contributing to increased sales. In the graph at the bottom, you can see our quarterly development in sales out that distributors and resellers report to us measured in dollars. In the second quarter of 2023, sales out increased by 49% organically compared to last year, with an increase in the case category of 60%. This shows an increased demand and great interest in our products. As Hannes mentioned earlier in the presentation, the difference between net sales and sales out is explained by channel stock filling dynamics. Going forward, we expect net sales and sales out to be more at the same level. Sales out has been on a high level during the last 3 quarters. And in the second quarter, it amounted to $17 million, the same level as in Q1. This is the highest level in over 2 years. Moving on to the next slide and segment development. The strongest region in the quarter was EU with net sales of SEK 153 million, corresponding to 62% of total net sales compared to 31% last year. The growth was mainly driven by a pent-up demand, successful product launches, increased demand from end customers and also low inventory levels at retailers. Americas net sales amounted to SEK 60 million, which is 25% of total net sales. And APAC and other amounted to SEK 32 million, which is 13% of total net sales. Sales of cases was 92% of total net sales compared to 87% in the same period last year. Moving on to the next slide and product margin development. In the second quarter, product margin was 40.2%, which is 9.5 percentage points higher year-over-year. The factor that mainly affected the margin was primarily lower shipping costs by 8.9 percentage points due to lower shipping prices. Current prices remained at around $2,000 per container compared to the peak of prices in late 2021 and early 2022 of approximately USD 20,000 per container. Furthermore, Americas percentage of total net sales was lower 25% compared to 41% in Q2 2022, which also leads to lower freight costs. During the period, margin strengthening initiatives have been taken, and we see good potential to have a positive effect on the margin during the coming quarters. Let's have a look at the next slide and earnings. In the second quarter 2023, EBITDA was strong and amounted to SEK 48 million, and the margin was 20% compared to minus SEK 3 million and minus 3% margin last year. The increase in EBITDA was due to increased sales and strong product results. As expected, sales and marketing-related variable costs increased due to the sales growth. Warehouse costs continue to be at a lower level compared to the previous year due to lower inventory. Personnel costs increased due to the yearly salary review, new hirings, primarily within the product development department and increased bonus provision due to the strong results. Operating cash flow was strong and amounted to SEK 64 million compared to minus SEK 8 million in the same period last year, positively impacted by higher EBITDA. We are very satisfied with the development of the cash flow, which is a receipt of hard efforts. The strong cash flow will enable us to invest in our continued growth. The change in net working capital was mainly related to increased accounts payable, inventory and accounts receivable due to stronger sales. When closing the second quarter, the bank overdraft facility amounted to 0 compared to SEK 132 million year-over-year. We had net cash of SEK 13 million compared to net debt of SEK 127 million last year. Moving on to the next slide and the income statement. As previously presented, we had an all-time high net sales in Q2 with an increase by 157%, mainly due to increased demand in the market and low channel stock. The product margin was positively affected by lower shipping costs, which has normalized compared to last year. Other external expenses increased mainly due to variable costs related to sales and marketing. Variable costs in percentage of sales was in line with expectations and last year. However, warehouse cost was lower due to lower inventory level. Financial net was in line with last year and positively affected by FX. We had a lower utilization of the overdraft facility, but higher interest rates. With that, I hand over to Hannes again.

Thank you, Karin. So we are reaching the summary here of the Q2 presentation. We continue to grab market shares, which is thanks to a very attractive product portfolio. It's very clear that we're growing much faster than the markets. Our net sales in SEK grew by an astounding 157%. We have a solid product margin of 40.2%. EBITDA margin came in at a healthy 20%. And as Karin just mentioned, we had a very strong cash flow development leading to a net cash position, which is very encouraging and will assist our future growth. The exceptional growth was driven by high demand and increased -- significantly increased sales outgrowth and built up channel stock to reflect increased demand. And as mentioned, we now consider the stock buildup to be completed and expect sales in and sales out to harmonize in coming quarters. The continued success of our newly launched products, combined with our expanded sales and marketing efforts gives us confidence in our ability to drive profitable growth in 2023 and beyond. And this year will most certainly be our most successful year ever. And with that, we have reached the end of the presentation. We thank you for your time, and we go over to questions.

[Operator Instructions] The next question comes from Simon Granath from ABG Sundal Collier.

And congrats on the strong execution. Initially, I think the topic on the PC refresh cycle from the search in 2020 of new gamers is particularly interesting. Did you see any impact from that in Q2? And also, could you remind us on the average replacement cycle for your products?

Right. No, that's a good question. Well, we see that the market has come back to a healthy growth, the overall market has not yet really seen the bigger growth. It's -- we estimate that the overall market is growing in the single digits still, which means that we are grabbing significant market shares. So we still believe that a big part of this upgrade cycle from the pandemic in search of new gamers is still ahead of us. And to answer your second question about upgrade life cycle, we typically see about 2 to 3 years average life cycle for our customers -- our cases primarily -- case system.

That's very clear. You mentioned that inventory levels have normalized. Could it be that they are even on the conservative side, given the resale -- the fact that resellers come from a weak period in terms of demand, hence, they would unlikely want to build excessive inventories in that current situation. I know you gave some wording on this, but I want to understand the risk of inventory levels being excessive or not?

Right. Yes, that's a good question. I mean, we started the year with actually much too low inventory levels and our sales channels. So there was a need to get them back up to a little bit normal level. But as the run rates have increased all our channel partners need to increase their inventories to match this higher run rate, and we believe now that they have quite healthy inventory levels compared to the run rates should the run rates increase even more, of course, they would need stock even more. But as you also mentioned, most of our channel partners have had issues with overstock during 2021, 2022. So they're naturally a bit hesitant to building up too much stock. So for that reason, and the numbers we are seeing, we don't believe that our sales channels are in an overstock situation.

That makes perfect sense. And given the very strong H1 here, which is not only about an improving market, but also you have -- also you performing well as you emphasized, do you assess that most of the pent-up demand from the weak 2021 to 2022 has now been utilized? Or do you see more effect on that going forward?

Well, we actually believe that the majority of the pent-up demand in the market overall is still ahead of us. The overall market is back to growth, but it's in only single-digit levels. And we see this -- all these new gamers that came in during 2020 and '21 and upgraded their systems. They would likely need to upgrade in the coming years. So the big growth that we are seeing is not that something we're seeing in the market overall.

Interesting. And just finally, on OpEx. You said that the increase here mainly stemmed from variable costs. I know you also made some comments on personnel costs, et cetera. But on the other growth initiatives, could you mention or comment on how they have developed in Q2 and also the trajectory to expect looking ahead?

Well, our growth initiatives, we work on various things. We have launched the Fractal Creator Program during Q2. It was actually silently launched last year, but we launched it publicly in Q2. That is a relatively cost-efficient program. We're also working with expanding our sales network. We see significant growth on Amazon, for example, which is very positive, which is a sales channel that we have not been very well represented in over the years. Another very important growth initiative for us is entering new product categories, something we have been working on for quite a while and we have interesting new products in new categories that are coming up. And we are seeing that we can launch them next year.

And you mentioned that you see them being launched next year. Any color to add on that, whether it could be in H1 or H2? Or do you keep that for yourself?

Well, we see that H1 has been exceptionally strong. And as we mentioned, we see now that the stock buildup is complete, and we believe sales out and sales in to be better in tune in the coming quarters. We're still seeing significant sales out growth in the market. So we believe H2 to be strong, but we will not see this channel filling dynamics that we saw in H1.

The next question comes from Amar Galijasevic from Carnegie.

I have a couple of questions here, but I'll start with one thing you didn't talk too much about in this presentation. The new partnership with iBUYPOWER. Would it be possible for you to give us any more comments on this partnership and when it will be visible in the numbers? And also, how large is the integration segment for you today? And what could it be over time?

Right. Yes, that's an interesting topic. We signed this deal with iBUYPOWER recently. iBUYPOWER is the largest local system integrator. And there is potential for us to have a significant business with them. It's still early days and hard to say and hard to quantify how big that would be. So I would like to refrain from that. Our system integration business is currently fairly small share of our sales, but we see a quite strong demand in the system integration area and believe that it will be a growing part of our case business going forward. Our newly launched products, such as the North, for example, has sparked a lot of interest among system integrators. And Fractal is planning to also be more active in the system integration area and allocate resources for that.

Okay. Great. That's super helpful. And just a follow-up question on gross margins on your products that you sell through iBUYPOWER, are they significantly lower than what you sell through resellers?

It is typically quite similar. Sometimes system integration margins can be a bit lower than retail, but it's not a big difference.

Okay. And another completely different topic. I was wondering if you could give us any update on the current tariff situation for you guys? And what the effect would be if you don't get an extension past September this year?

Right. Yes, we have a tariff exemption for cases that is expiring on 30th of September. We have received the tariff exemption now 3x since 2020. So we're quite hopeful and confident that it will be renewed another time. However, the visibility in that process is very poor and has also been so in the last couple of times, it has been renewed, and we will likely know about renewal very close to the expiration date. If the exemption would not be renewed for some reason, which, again, we believe is unlikely, it would be a negative effect on our profitability as we would have to pay tariffs on all the cases that are shipped to at the U.S. market. We do have -- however, have some backup plans in case that would happen, which would involve moving certain production out of China into adjacent production countries, such as Vietnam and Thailand. That would take some time until that's executed. And since we now believe that there is a good chance we can get this assumption renewed, it's not something that we are working actively on. But we have those plants laid up and we can execute on them if needed.

Okay. That's very helpful. And just a final question from me here on the OpEx in Q2. Just to be completely clear here, should we view this as a new base level for personnel expenses? Or was it a big onetime bonus here? And also for the other external here, is the Fractal Creator Program a big cost in that bucket? Or just how should we think about that going forward?

Right. Yes. So the personnel costs are increasing slightly, and that is a result of that we are in need of expanding our team. We are investing in several different areas, both sales and marketing and also especially the new product categories that we want to launch, which, we believe, can contribute to significant growth to Fractal. And a lot of those personnel-related expenses are, of course, coming in, in advance of revenues. In terms of the other costs that we see in this quarter that sales and marketing-related expenses is bigger, and that is as a result of our increased efforts, which also includes the Fractal Creator Program that you mentioned. We also had some costs related to a product rework that we had to conduct in the quarter, which is more of a one-off characteristics. All right. Then we move on to the written questions we have received.

Yes. So the first question we have says, congratulations on a very strong quarter. Our questions are below. Your sales growth were very elevated above the also high sales outgrowth, do you have any insight into a normalized inventory level for resellers where inventory is low and now normalized over inventories normalized and now high? And this is something Hannes previously discussed and the situation was that the inventories were low and are now normalized. The next question was, in 2023 Q1, you mentioned that product mix had a negative effect compared with previous quarters of 8% that you expected this to disappear over time. What is the effect of product mix in Q2 2023? And in Q2 2023, the net effect of product mix is more or less 0. We had more sales of cases 92% of total net sales was cases compared to 87% last year. So that helped our margin. However, we still have some lower margins within the case category. And as we talked about last quarter, this is something that we are working on, and we are improving the margins on those products. And of course, that is a lag effect, and we need to sell out from stock, older products before we can see the effect, but initiatives are -- we have taken initiatives to improve the margin. Next question, external cost increased by some 50% in the quarter. Could you expand on what the major driver behind this is? And this is what Hannes just described. So I hope the question is answered. What is the status on launches of new adjacent product categories? Hannes also answered that. So I hope that is satisfied. And the last one, same there, the U.S. tariff situation. We have asked -- answered that question too. Moving on to next question. How come the gross margin was slightly lower this quarter compared to Q1? And in Q2, we had a product margin of 40.2 and in Q1, a product margin of 40.4. And there are several reasons to that. I mean, within product margin, we have a lot of different drivers, such as product mix, sales discount, we have freight, FX, tariffs and other things. And what we can see in Q1, for example, we had a positive effect of FX of 2 percentage points. So that was a driver then, which we don't have now. So a little bit mix of everything actually, but FX could be one of them. Next question, could you elaborate on the potential to increase product margin? What are the drivers? And what are the risks? And when we see the product margin now, we -- as I said, we have -- we see good possibilities to improve our purchase prices. Of course, given continued low raw material prices and also positive currency effects. So renegotiated purchase prices will give a positive effect. However, before we see the improvement [ meant ] in the numbers, we need to sell out products from stock with higher purchasing prices, which I talked about before. So there is a lag effect. And we have also been able to make some price increases for many other products, mainly due to lower freight costs. And for the main part of these price increases, that doesn't affect the end customers, anything. So the freight cost has gone down. So we've been able to increase prices to our customers. So these two are the main drivers.

Just to chime in there a little bit, Karin. So on the risk side, we -- I would say there are two main areas, which is a bit out of our control and that is the currency risk. We buy stock in U.S. dollars and sell in U.S. dollars, but when it's purchased it's being converted into SEK. And right now, the currency level is -- USD to SEK is relatively high, would that go down very fast. It could have a negative impact on our margin. The other area is the freight costs, which was extremely elevated in 2021 and '22. And they have now come back down to normal levels. We don't see that as a big risk of them going up significantly again because if you look long term, historically, they have typically been at the levels where we are right now. So we believe this is the normal level and the kind of crazy high shipping costs we saw in '21, '22. We believe, and I think most believe that, that is an anomaly.

Yes. So moving on to the next question. How will increased sales on Amazon impact your gross and EBIT margin? I don't know if you will answer that, Hannes?

Yes, I can take that. Well, the sales to Amazon is not having a negative impact on our gross and EBIT margin. It will be fairly similar to margins we see through other sales channels. So the potential here is rather on the upside we see by being properly represented and active on Amazon. We add a very important sales channel, which could potentially increase our sales over time.

And the last question we have is, if possible, I would like a little more color on the potential launch of adjacent product categories. And I think we talked about that before, Hannes, I don't know if you want to add something to that discussion?

Yes. We are not public exactly which categories we are going into. We have mentioned that we plan to launch them next year. It is, as discussed, adjacent categories, which mean that it's related to our current categories and it's something that we believe, have a very similar version of the customer group. We have developed this now for quite some time. And we are eagerly looking forward to entering into new categories. We see this as most significant mid- to long-term possibility to Fractal to grow substantially by entering new categories. And we believe that the categories that we have chosen matches the Fractal strategy and identity very well and that we also have the capability of offering innovation into these categories. But of course, at the same time, we are humble that it's challenged in new categories, but we will work hard to make those a success. Furthermore, as we've also mentioned in previous presentations, we are actively looking into M&A, the possibility of acquiring another company that is active in decent product categories to further accelerate our entry into new categories. So our overall strategy is to end new categories, both organically, which we've worked on for quite a while and also to try to find nonorganic opportunities.

Good. That was the last question.

All right. Thank you all for your time today and I wish you a great day.