I am recommending a short position in Gree (3632 JP), a Japanese mobile social gaming company, whose stock price has at least 40% downside despite large recent declines. In my opinion, Gree's absurdly profitable and explosive growth (~100% revenue growth, ~50-60% EBIT margins, ~140% returns on tangible capital even after 40% taxes) is coming to an end as result of: 1. Entrance of new competitors into mobile gaming by such competitors as DeNA; 2. Opening up of social networking platforms to outside developers; 3. Opening up of mobile carriers platforms; and, 4. Emergence of smartphones in Japan.

As the business is fundamentally changing (commentary on that later), I numerically focused on economic return, market size and margin benchmarks from industries that this company's industry might resemble in the future as opposed to existing unit economics. Here is a summary of some very rough starting assumptions:

1.      I assume that the market size for mobile social gaming will eventually represent a ~¥325bln annual opportunity based on 90 million of ~120mln total mobile subscribers spending ¥300 per month (Gree's current ARPU is ~¥200 versus ~¥ 300 for DeNA). This compares to Barclay's and UBS's estimates of about ¥90bln and ¥100bln for the current market size of mobile gaming and internet gaming, respectively. I believe that ARPUs are significantly inflated by the lack of competition, especially as access has been limited by carriers (which is changing). For an imperfect point of reference,  here is a table of comparable ARPUs for various internet companies.

            The monopolist type returns (below) that Gree and DeNA generate are evidence, in my opinion,      of inflated ARPUs relative to what the companies provide.

2.      The EBIT margins for this type of business I assume will be a generous 15% which would accord Gree an after tax return on tangible capital of over 30%, even assuming an inordinate amount of its' cash pile is necessary (usual Japanese cash hoarding).

3.      I assume that Gree will have a 25% market share of this spend. Taking just DeNA's gaming revenue and Gree's "fees" (includes avatar fees), Gree's share has already dropped to 35% in the latest quarter. Market share is an elusive statistic as company disclosures vary and new competitive channels mask other competition.

4.      I assume that Gree will generate 35% of its' sales from in-house developed games and have to pay 80% of revenues from outside developed games to their developers. Gree currently has 5 in-house developed games with the latest taking 21 months to introduce compared to over 40 from its' new open platform and over 150 on DeNA's open platform.

5.      Gree's valuation deserves a generous 20x EV / EBIT multiple on the year in which the market matures and profitability normalizes.

Here are some of the numbers in an admittedly simplistic valuation:

Competition

Direct competition, especially from DeNA, is starting to present strains on the economics of these businesses.  With Gree's financials this can be seen in slowing growth (admittedly this is also due to maturation) and increasing SG&A costs both as % of sales and per "user."

DeNA has not had the same SG&A pressure, partly because they are winning in my view, but has definitely diminished shareholder returns to drive growth via acquisition. DeNA recently paid ¥34.2bln (~$400mln) for ngmoco a company estimated to have generated $10-20mln in revenues and valued at $100mln months earlier in a previous financing. Additionally, DeNA used equity despite significant balance sheet cash.

Opening of platforms

Gree opened its' platform, forced in my opinion, to outside games mid 2010 as DeNA's performance exploded after opening to outside developers. Now, incumbent companies' (Gree, DeNA etc) in-house gaming teams will have to compete with outside talent. Additionally, this should give outside developers more negotiating leverage.

In addition to DeNA gaining share, I believe that Gree will also cede share to social networking sites given that its' users connect via avatars limiting the channels of socialization.

Zygna, probably one of the closest analogues to Gree, apparently received $150mln from Softbank as part of collaboration to bring new games to the Japanese market.

Opening of carrier platforms

Gree's and DeNA's successes have certainly been aided by the fact that mobile phone users have given limited choice within carrier's "walled gardens." I have wondered why carriers have not taken more of the economics from the social gaming companies, and this might be starting to change. First, carriers are allowing more platforms into their system (KDDI - Gree's initial backer into mobile gaming -  allowing ReKoo, a Chinese social gaming company, to sell to its' users)  . Second, carriers are starting to develop their own "app stores" and try to take back management of subscribers "social graph" (basically owning the social connection process).

Emergence of smartphones

The appearance of smartphones running iOS (Apple) and Android should increase the access of third party application providers, through standardization; even if Japanese carriers are successful in retaining control over servicers that users can access. Between carriers allowing new game makers and smartphones, it seems unlikely that any company will be able to permanently earn monopolist economics as a result of limited consumer choice.

Some background info:

http://www.socialtimes.com/2010/10/social-gaming-wars-the-eastern-front/

http://search.japantimes.co.jp/cgi-bin/nc20100915aa.html

http://www.mobinode.com/2010/09/11/japanese-social-gaming-platforms-chinese-developers-jonesing-to-get-in/

Despite being only a teaser for a costly report, these slides have images of typical games and functionality (along with DeNA background):

http://report.infinita.co.jp/samples/mbga_Report_2_0_Samples_Infinita.pdf

Here is an article about the company's founder that has some background:

http://www.forbes.com/global/2010/0118/japan-rich-list-10-green-google-networking-early-riser.html

Risks

I am not a local investor, so I could be missing something that makes Gree different/better.

I assume that Gree will not do much overseas given their lack of interest or effort in that so far. If this changes and the Company is not behind the curve, the addressable market could be much larger.

Continued influx of tremendous amounts of capital into social gaming globally (DeNA buys ngmoco for $400mln; Softbank invests $130mln in Zynga; Disney buys Playdom for $700mln;... ).

More competition allowed by Japanese carriers.

Deteriorating economics.