Gravity GRVY
December 29, 2006 - 6:11pm EST by
2006 2007
Price: 5.85 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 163 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Gravity (ticker GRVY) is a stock with limited downside risk due to its valuation and the potential for significant appreciation (100%+) as it approaches the peak of its earnings cycle, which should occur in 2008.  Value realization could actually come well before the arrival of peak earnings as there are two activist hedge funds committed to improving the stock price.


Gravity is trading under $6 with over $3 of net cash and peak earnings power of around $1 (could be as high as $1.50 or as low as $0.50 depending on assumptions).  Peak earnings should occur in 2008, and if they come in at $1, it’s hard to imagine the stock not trading at least at $11  (8 P/E + net cash) and it’s conceivable it could trade a lot higher. 


In addition to the fundamentals, there is the possibility that there will be a buyout of the company’s shares in the next 6-12 months.  In August 2005, EZER, an affiliate of Softbank, purchased a 52.4% stake in Gravity from Gravity’s founder and former Chairman, Kim Jung Ryul.  EZER paid an estimated $24.70 per share, or 3.5x Gravity’s then trading price of $7.10 per share.  EZER declared in an SEC filing that it had acquired the stake in Gravity to secure a continued licensing deal for Gravity’s Ragnorak game for another Softbank affiliate, GungHo Online Entertainment (Bloomberg ticker 3765 JP).  Not only were the minority shareholders not taken out, but EZER said in the filing that they would not pay over $7.10 per share for the remaining shares outstanding, and further threatened to have the stock delisted from the NASDAQ and raised the possibility of using its voting power to force a sale of all the company’s assets  The ultimate money behind this flagrant screwing of minority shareholders is not some small cap or private Asian entity but in fact Softbank (ticker 9984 JP), a Japanese technology conglomerate with a $20+ billion market capitalization.  Softbank is run by Masayoshi Son, a prominent Japanese business leader and billionaire, the 221st richest person in the world,  and father of Taizo Son, the Chairman of GungHo Online.  Given the presence of two activists with substantial resources and a demonstrated tenacity and unwillingness to roll over, it seems unlikely the company will be stolen without a legal battle, and that a takeout below the IPO price (up 100%+) will be accepted.


Company History and Business Model

Gravity is headquartered in South Korea but trades exclusively on the NASDAQ as an ADR.  It develops and distributes MMORPG (massively multi-player online role-playing games) throughout the world, with the primary source of revenue being East Asia.  MMORPG (think a high-tech, internet-enabled massive game of dungeons and dragons) are extremely popular in Asia, where players often spend 4 hours or more per day playing the games, and there can be tens of thousands of players competing against each other during peak hours.  The game experience is addictive, and the more time one spends playing a game, the more powers they will obtain, allowing them to advance to a higher position versus their fellow players.  The result is that the game becomes a hobby, and the time investment breeds loyalty to a particular game.  Since a majority of revenues come from monthly subscription fees, this loyalty is important because it leads to a high percentage of revenue derived from a recurring revenue source.  The more loyalty, the less churn, and the more stable the revenues.  As evidence of the level of devotion that people have to these games, it is not uncommon to see a secondary market in MMORPG powers trading on eBay.  Gravity’s primary product is the Ragnorak game, which is among the most popular in Asia.  Ragnorak really started taking off in 2003, and reached max popularity in 2004.   Capitalizing on the game’s popularity and the company’s revenue growth (300%+ in 2003 and 50%+ in 2004), Gravity was taken public by CSFB in February of 2005 at $13.50.  It has been a broken IPO from the start and quickly became an orphaned company in terms of coverage.  It has no sellside coverage; CSFB used to cover it but dropped coverage shortly after the majority interest in the company was sold in August 2005.


The popularity of the Ragnorak game remains solid but is clearly waning as company revenues in the first half of 2006 were down 29% year-over-year in US dollars.  Like all game companies (both online and traditional packaged games), Gravity’s revenues and earnings peak following the release of new games.  There is a lot of operating leverage in the business because costs (R&D/software development, G&A, etc.) are relatively fixed regardless of where revenue levels are.  Additionally, spending ramps ahead of revenues, both for R&D and marketing, such that the company has trough profitability (and may even lose money) in the period right before a launch.  Revenues are earned through both upfront licensing fees (usually $1 million to $3 million per region depending on the size of the region) and a revenue share of subscription fees (typically 20-30%).  In all regions other than South Korea and the US, Gravity has a distribution partner who markets the game, collects and processes subscription revenues, and manages the servers and other technology required to deliver the game. 


For Gravity, earnings and revenues peaked in 2004.  In 2004, the company made a little over $1 per share (around $30 million) and had a 60% operating margin.  In the first half of 2006 (a period of trough profitability), the company lost about $2 million, and probably would have broken even or made a little money without the one-time expenses associated with fighting the activists and litigating against the former Chairman, who was found to have embezzled money prior to selling out his share of the company (the funds were since recovered).  With a market cap of $163 million and an EV of $78 million (there is $85 million in cash), the company trades at well under 2x the peak EBITDA of $45 million achieved in 2004.  NCSoft (ticker 036570 KS), another Korean MMORPG maker, trades at well over 10x EBITDA and a 16x TTM P/E (these are probably peak earnings).  That company relies heavily on one game, Lineage, and was successfully able to migrate users profitably to its sequel, Lineage 2.  In both online and packaged games, there are many examples of sequels meeting or exceeding the profitability of their predecessor game.  Applying a 8-12 P/E on $1 and adding the cash balance yields a $11-$15 fair value range for Gravity (+88% to +156%).  Even without the presence of activists, Gravity looks like a good fundamental bet based on valuation and business cycle.


The Activist Story

Ramius Capital and Moon Capital, hedge funds with a combined $8 billion in assets under management and a 16% combined stake in Gravity, have taken the lead in protecting minority shareholders rights.  Ramius and Moon have succeeded in organizing a minority shareholders committee.  They have pushed for the removal of executives and directors who have represented EZER at the expense of other investors and an investigation into certain related party transactions.  They have also raised public awareness about the continuing investigation and allegations of embezzlement against Kim Jung Ryul.  They have even intimated that representatives of EZER aided him in this fraud.  On December 26, 2006, a vote was taken on a proposal to remove the CEO and COO of Gravity (both EZER appointees).  The vote was obviously impossible to win, given EZER’s 52% voting majority, but the results, which were frankly outstanding, should serve to apply additional pressure on EZER and Softbank.  An astonishing 97.4% of minority shares outstanding voted to remove management.  This represented an equally remarkable total of 87% of minority shareholders.  ISS, the proxy advisory service that rarely recommends voting against management, recommended a vote against management in this instance.  Whether through the courts or through the press, this vote should give Ramius and Moon substantial leverage as they continue their fight against EZER.


One obvious concern has been the maximization of the revenue opportunity in Japan for Ragnorak 2.  The company is currently negotiating upfront licensing fees and revenue share agreements for Ragnorak 2.  Given that the negotiations for the Japan license are with a related party, GungHo, it is safe to assume that maximum value will not be obtained in Japan, which represented about 20% of peak revenues for the first Ragnorak.  GungHo, which derives 95% of its revenues from distributing Ragnorak, currently has a market cap about twice that of Gravity’s ($332 million) and trades at 216x TTM EBITDA and a 68 P/E.  Gungho was down 83% in 2006 and around the same amount from where it traded before EZER bought its Gravity stake.  With GungHo trading at a 400 P/E with limited financial resources and a business model completely reliant on securing the Ragnorak 2 license, it is pretty clear why Softbank orchestrated the purchase of a majority stake in Gravity.  Terms to Gravity should have been much more favorable with Ragnorak 2 than Ragnorak 1 given GungHo’s prior state of desperation, but clearly given the control stake, value will not have been maximized by the recently signed Ragnorak 2 agreement (the deal terms have not been disclosed).  The independent shareholders can only hope that the terms with GungHo on Ragnorak 2 were at least close to those on Ragnorak 1, even though that means money left on the table.  Ramius and Moon are currently pressuring Gravity to release the terms of the Japan license.  Fortunately for independent shareholders, 80% of Gravity’s business has historically been with parties that remain unrelated.  In a recent conference call, management indicated that they are being tough in their negotiations with various licensees, so there is some hope that better terms in other major territories (e.g., Taiwan and Thailand) may offset what could be weaker terms in Japan.


Outlook and Price Target

The most probable outcome to the activist initiative would be a minority share buyout at the IPO price of $13.50 (+130%).  If the activists can be enough of a gadfly to the company, the easiest path of resistance for EZER and Softbank will likely be a buyout, especially given Softbank’s deep pockets.  The maximum imaginable return is $24.70 (+320%), which is the price EZER paid for Chairman Kim Jung Ryul’s stake.


Even if the activists fail and EZER does not buy the remaining minority shares, GRVY is still worth at least $11 (+88%) and possibly quite more on fundamentals alone, and earnings should start getting better in mid 2007 and peak in 2008.  Over $3 net cash per share on the balance sheet (or 52% of current market cap) provides a large degree of downside protection.



1.      Financial results start to improve with the commercialization of Ragnorak 2 in 2007 and the company starts trading at a reasonable P/E multiple

2.      Activist hedge funds succeed through legal or PR efforts in forcing a buyout of the minority shares, likely at a premium of 100% more



1.      Ragnorak 2 does not achieve the popularity of the original Ragnorak, or its release is delayed pushing earnings recovery into 2008 from 2007

2.      EZER attempts a take-under of the minority shares, either through a public tender or through a purchase of the bulk of the firm’s operating assets at a below market value (there are legal protections against this scenario in both US and South Korean law)


1. Financial results start to improve with the commercialization of Ragnorak 2 in 2007 and the company starts trading at a reasonable P/E multiple

2. Activist hedge funds succeed through legal or PR efforts in forcing a buyout of the minority shares, likely at a premium of 100% more
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