GRAVITY CO LTD -ADR GRVY
January 27, 2010 - 5:39am EST by
hack731
2010 2011
Price: 1.67 EPS $0.29 $0.50
Shares Out. (in M): 28 P/E 5.8x 3.3x
Market Cap (in $M): 46 P/FCF 5.7x 3.2x
Net Debt (in $M): -62 EBIT 11 15
TEV ($): -16 TEV/EBIT NA NA

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Description

 

GRVY continues to trade well under net cash ($2.2 per share) with modestly profitable operations and a significant catalyst on the near-term horizon: launch of Ragnarok Online 2 (RO2) this summer. Company IR has now confirmed to me twice - including today - that RO2 will launch this summer (though there is some risk of further delays).

As we know, GRVY is an online (PC) game developer in South Korea. As background, the worldwide online (PC) gaming industry has grown about 10% a year from 2005-present (primarily from growth in Asia).  As of September 2009 (end of last reported quarter), GRVY had cash and short-term financial instruments of 72,878 million KRW, which is $62.4 million, or $2.2 per share with 27.8 million ADS. Importantly, the company said they are only considering small investments or acquisitions (under $5 million), so cash balance should continue to build.

For nine months ending September 2009, sales were $38.0 million (+17% y/y), with gross profit of $24.1 million (+73% y/y) and EBIT of $8.5 million (negative in 2008). NI was $6.2 million, with EPS of $0.22. That implies that annualized EPS is $0.29 and shares are trading at 5.8x annualized EPS.  

Gravity was formed in April 2000 and went public on Nasdaq in February 2005 at $13.5 per share (raising $71 million) on the success of Ragnarok Online (which was commercially launched in 2002). In 2005, EZER, an affiliate of Softbank, acquired the shares of founder and former Chairman Kim Jung Ryul at close to $25 per share. Later, GungHo (3765 JP, a Japanese company now owned 34% by Softbank), in a series of transactions, acquired a 52% stake in Gravity. GungHo then acquired another 7%, taking its stake to 59%. As background, Taizo Son (Chairman of GungHo; owns 34% of GungHo) is the son of Masayoshi Son (Chairman of Softbank).

A new CEO, Yoon Seok Kang, joined in 2008 and has cut costs and eliminated the legal and embezzlement problems surrounding the former chairman. Cost cuts included reducing salaries at headquarters and closing U.S.-based L5 Games . Sales have also improved modestly in 2009. Furthermore, the new CEO has helped resolve the company's legal issues surrounding the former Chairman. In December 2009, GRVY settled with Softstar Entertainment, a Tawian online game developer and GRVY's license partner for Taiwan and Hong Kong in 2005, for $2 million. In December 2009, GRVY also settled with YNK Korea, a former investor in Ragnarok Online for about $0.5 million. After these two settlements, the company is purportedly not involved in any lawsuits, fully putting the former chairman's legal issues behind them.

Ragnarok Online is the main driver for the company, at 70-75% of sales. Ragnarok Online was commercially launched in 2002. The game grew rapidly in popularity and reached peak subscribers in March 2005. Ragnarok has been the top online (PC) game in Japan since 2005. Ragnarok is also reported to be the top online game in Taiwan, Thailand, Malaysia and Singapore. Ragnarok is currently offered in 38 countries and 14 languages. In late 2006, the company started offering a "micro-transaction" system in Japan, which enables customers to buy in-game items and points (in order to advance faster in the game), which now represents over 25% of Japan sales and over 50% of Thailand sales. Customers still pay the traditional way (by month or hour if they are on a home-PC; by hour if in an Internet cafe).

Japan is the company's most important market (about 50% of company sales). GungHo is the leading online game publisher in Japan and has the license for Ragnarok (and has the license for RO2). GRVY has disclosed terms of its licensing agreement with GungHo for Ragnarok (renewed for three years in September 2009), but the terms of the licensing agreement for RO2 has not been made public. With such a major release and with its major shareholder controlling the license in its most important market (Japan), there is risk that GRVY could get the short-end of the stick. However, in a 1-on-1 meeting with company IR, company IR hinted that the licensing terms for RO2 are similar to Ragnarok Online.

Clearly, the near-term catalyst for the company is the launch of RO2. As background, RO2 has been in Open Beta Testing since May 2007 and currently has a decent-sized staff, including 24 designers, 9 programmers and 11 game planners. As background, total headcount at the company is around 360, including over 80 people in customer support. Importantly, RO2 will have some major changes (including having the characters in 3D), which the company believes will help it succeed in markets like Korea and reduce the potential cannibalization of Ragnarok (which has characters in 2D and a loyal customer base, especially with teenage women in Japan).  While the game has experienced several delays (some bugs; some staff losses; some cultural changes to the game for several licensees) and could have further delays, company IR has twice confirmed - including today - that RO2 is set for launch this summer.

It is hard to gauge the potential earnings power of RO2. But, with the company already modestly profitable and trading well under net cash, we don't need much of a sales contribution for earnings to grow nicely. The company will likely ramp advertising spend somewhat, but the licensing revenue and guaranteed payments could be significantly higher. Based on its November 2006 press release, the company is expected to receive at least $23 million from GungHo (licensee for Japan) and Asiasoft (licensee for Thailand) in license fees and guaranteed payments over the first three years of the launch. Based on a January 2007 press release, the company is expected to generate another $31.5 million from The9 (licensee for China) and Gamania Digital (licensee for Taiwan, Hong Kong and Macau) in license fees and guaranteed payments over the first three years of the launch. That implies annual license fees and guaranteed payments of at least $18 million a year for the next three years (just from these major licensees). The company has a total of 9 licensees in ten countries, with the smaller licensees perhaps adding another $2 million a year. So, if advertising spend increases by $5 million, then at least $15 million a year would become EBIT. At 22% taxes, that's an increase of $11.7 million in NI. With run-rate NI of $8.3 million, that implies NI of $20 million, or EPS of $0.72 with 27.8 m ADS. A multiple of 8-10x (perhaps peak) EPS could put the stock at $5.75-$7.20 (up 250-350+% from here).

Meanwhile, we can wait it out with the stock trading well under net cash per share.

Catalyst

 

Release of Ragnarok Online 2 (RO2) in summer 2010, or shortly thereafter

GungHo attempts to maximize value of its 59% stake through driving greater profits of GRVY

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