Description

Investment Thesis Summary 

I believe that an investment in the common shares of Gravity (trading on the Nasdaq, ticker: $GRVY) is compelling for the following reasons:

• Gravity’s sales and profit growth accelerated in Q4 2022 with the launch of Ragnarok Origin in Taiwan/HK. I expect that the momentum in top-line and EBIT will continue as the company releases RO in SE Asia and globally.

• GRVY’s valuation is extremely asymmetric. GRVY is currently trading at ~2.0x ‘24 EBITDA or a +35% FCF yield, but the downside is limited by the company’s net cash balance ($50+ net cash/share vs. $72 current price).

• The company’s growing cash pile provides for significant optionality through possible repurchases, dividends, or thoughtful M&A.  

• The company’s game pipeline could provide valuable diversification of earnings and further upside if the company develops another hit game.

All-in, I see a path for the stock to be worth at least $180/share, or about 160% upside from today’s current price.

 

Why this might be mispriced:

• Orphan asset: Gravity is a Korean gaming company that trades solely in the US. I believe that this creates few if any, natural buyers of the stock.

• No sell-side coverage: There are no analysts that cover $GRVY. Hence, there are no estimates.

• Small-cap and illiquid: the company’s market cap is ~$500m, which might be too small for most funds. Liquidity is somewhat limited, with an average daily traded volume (ADTV) of ~$1.6m USD per day.

• Controlled company: GRVY is controlled by its largest shareholder, publicly traded GungHo Online Entertainment (ticker: $3765.JP), which owns 59.3% of the company. This presents risks to minority shareholders.

• Questions re: capital allocation: the company has a history of simply piling cash on its balance sheet, which gives investors pause.

Capital Structure

Gravity has a market cap of ~$500m USD and an enterprise value of ~$210m. The company has close to 60% of its market cap in net cash.

 

Business Background

Gravity is a developer, distributor, and publisher of online games in Asia. The company derives c. 80% of its revenue from mobile games and c. 20% from PC-based games. The company is headquartered in South Korea but trades exclusively on the NASDAQ as a sponsored ADR. More than 50% of the company’s revenue comes from Taiwan, Hong Kong, and Macau. Another 25% comes from Southeast Asia; the remainder comes from countries including the US, Brazil, and others.

The company traces its success back to the 2002 release of a popular MMORPG (massively multiplayer online role-playing game), Ragnarok Online. Despite the game’s age, GRVY has extended the life of its IP by continuously releasing new updates. Since 2002, the company has released 30 additional games based on the Ragnarok franchise as either PC or mobile titles. Mobile games now generate the majority of the company’s revenue.

The company’s games are free to play and generate revenue through the sale of high-margin, in-game currency. Players can use in-game currency to purchase collectible items, etc. The advantage of this free-to-play model is that it broadens the potential audience for the game, as there is little investment or friction required to begin gameplay. The company’s games, multiplayer by design, also tend to bring a social element to the game which keeps people playing (and socializing) for longer.

A key to extending the life of the company’s games, like for many other video game companies, has been the introduction of live operation dynamics (“live ops”). Essentially, the cadence of releases has shifted from big “tent-pole” events to smaller and more frequent, incremental updates that are designed to increase player engagement.

Overall, I would qualify Gravity as a decent-quality business. There are a few key attributes that I would highlight:

• It is capital-light: CAPEX spending is minimal, at <0.4% of revenue per year.

• High operating margins: avg of 22-23%, with incremental margins >25%.

• There is little tent-pole risk, as the company has moved to a live ops model and constantly releases new, incremental updates. New game releases are also spread out by geography.

• Consistent growth: despite what is usually a “lumpy” model, Gravity has managed to grow revenue and earnings every single year.

Thesis

Gravity’s sales and profit growth accelerated in Q4 2022 with the launch of Ragnarok Origin in Taiwan/HK. I expect that the momentum in top-line and EBIT will continue as the company releases RO in SE Asia and globally.

 

• In Q4 2022, Gravity released Ragnarok Origin in Taiwan/Hong Kong, which has been a massive hit. Additionally, Ragnarok Next Generation continues to do well in South Korea. This resulted in revenue growing by +82% and operating profit growing by over 300%. This strength continued in Q1.

• I expect that operating momentum will continue with the launch of Ragnarok Origin in South East Asia in early April (Q2 2023). There have been numerous signs pointing to a big release, with the game having over 10m pre-registrations prior to launch, the highest number ever for any Gravity mobile game.

• Moreover, Ragnarok Origin is to be launched globally later this year. I expect that these releases, combined with the current momentum, will result in a new higher base of revenue and operating profit.

GRVY’s valuation is extremely asymmetric. GRVY is currently trading at ~2.0x ‘24 EBITDA or a +35% FCF yield, but the downside is heavily protected by the company’s net cash balance.

• At the current run rate, I estimate that GRVY will generate c. $130m USD in EBITDA for 2023. Given some potential lumpiness, I model a decrease in mobile gaming revenue for 2024 and an EBITDA of $105m USD. This puts the company at 2.0x 2024 EBITDA. Moreover, this is a very clean earnings number, with no add-backs; roughly 75% of EBITDA will convert into FCF.

• The company has significant cash on the balance sheet. As of Q1 2023, the company has close to $300m in net cash on the balance sheet - or about $42 USD per share in cash. I estimate that by the end of the year, the company will have roughly $52 in net cash per share relative to the current stock price of $72. If the company trades down to a zero enterprise value, your downside is limited to ~30%. I would argue that the quality of the business and the fact that it generates significant FCF should not merit that sort of draconian valuation.

• There are few public mobile gaming companies left. Most have been acquired by the larger studios. Although companies such as Playstudios / Playtika trade in the 1-2x EV/Revenue range and at a mid-to-high single-digit EBITDA multiple. While not perfect comps, they do point out the massive valuation discrepancy.

• Recent acquisitions have tended to occur at a mid-teens EBITDA multiple:

  • Rovio, the publisher of Angry Birds, was acquired for ~13x 2023 EBITDA.

  • Glu Mobile was acquired for ~17x NTM EBITDA by Electronic Arts.

  • Zynga was acquired by Take-Two in 2022 for ~18x EBITDA.

• I think an acquisition would not be out of the question. Ultimately, the company lacks the scale to develop bigger projects. A larger player with more resources and existing distribution could plug GRVY in and leverage its existing strong IP and recognition.  

The durability of the company’s IP is underappreciated.

• Investors have typically questioned the long-term viability of gaming franchises, despite increasing evidence that good IP can have insanely long useful lives. There are countless franchises that continue to have significant engagement despite having been released countless years ago. On the PC side, gaming franchise World of Warcraft comes to mind. On the mobile side, Candy Crush is the perfect example; the game was released in 2012, peaked in 2015 on an engagement basis, but still has close to 300m monthly active users, despite being over 10 years old.

• While Gravity does not count with the same left of popularity, the argument still rings true. GRVY has been effective in monetizing its core IP by extending and prolonging the life of its Ragnarok franchise. It has figured out ways to foster in-game spending through active “live ops” by providing continual game updates and special events that bring players back to the game. Ragnarok Online is still quite popular and monetizes well, despite being 20 years old. In the chart below, you can see the quarterly sales of the company’s PC game, which shows almost annuity-like income.

 

The company’s growing cash pile provides for significant optionality through possible repurchases, dividends, or thoughtful M&A.  

• Capital allocation has often been a cause of pushback from investors, as the company has not returned cash to shareholders through dividends or repurchases. However, this does not mean that the company will not return cash at some point in the future. The company is effectively controlled by its Japanese parent, GungHo, which does periodically return cash via buybacks. Given the controlled ownership, it’s not unreasonable to assume that the cash could be returned at some point, providing further upside.

• Importantly, the company has noted that it might be interested in pursuing an acquisition to diversify from the Ragnarok IP. While most investors think this might be an unfavorable scenario, I do not see it as a big risk. In the analysis below, I highlight several return scenarios if the company were to make an acquisition using 100% of its available cash (~$360m ending in FY23) at different EBITDA valuations (top/right) and assuming some re-rating (left). Given the undemanding starting valuation, the company could overspend on an acquisition and the returns could still be quite favorable. The analysis is a worst-case scenario, as it assumes the entirety of the company’s cash balance is used for M&A.

 

The company’s future game pipeline could provide valuable diversification of earnings and further upside if the company develops a hit game.

• A console version of Ragnarok - Harry Choi, a Business Director in the company, recently noted in an interview that the company is securing publishing rights for console games to develop the expertise to eventually launch their own console game, which could drive meaningful growth.

• Launch of a mobile game in mainland China - Gravity has tried multiple times to partner with Chinese firms to release current versions of its games in the mainland. However, this has not panned out given the current difficulties of obtaining new game licenses post the 2021-2022 crackdown. There are signs, however, that China is starting to ease up on the gaming sector and issuing new game licenses.

• Non-Ragnarok game titles in the pipeline - Gravity has developed new titles falling outside of its core Ragnarok offering, including an NBA game. Recently, it released a new game titled WITH: Whale in the High. The game has been downloaded +100k times, according to Google Play. Any hit is likely to be incremental to the company’s current earnings trajectory.

   

  

   

Valuation & Price Target

A few important notes on valuation:

• I value the business using a 9.0x EBITDA multiple on my ‘24 estimate of EBITDA (which is at a lower run-rate than ‘23). This would be more in line with other mobile gaming peers, although there are few good comps. In an acquisition scenario, the company could easily fetch more than 9.0x.

• At 9.0x EBITDA, my price target is $190 per share or about 160% upside.

• 9.0x EBITDA imputes a ~8% free cash flow yield and ~2.0x EV/sales, which strikes me as a reasonable valuation - not overly aggressive.

• The company is well protected in a downside scenario given $50 USD/share in cash by year-end. The downside is likely limited to ~30% in a worst-case scenario in the medium term (although keep in mind that stocks can trade anywhere in the short term). Earnings are somewhat unpredictable from year to year, but I think the downside should prove limited.

 

Model and Estimates

Here is a copy of my earnings model. It is also attached below.

Risks

• Mobile games are still hit-driven: While the IP has had longevity until now, there is a risk that new releases/updates might not resonate with gamers, and earnings might suffer.

• Game delays/cancellations: Game development can often take longer than management teams anticipate, and important game releases can be delayed or canceled, affecting earnings.

• Capital allocation risk: the company might destroy value by making a terrible acquisition, etc.

• Transparency from IR / management is very limited. It’s hard to get a sense of what the company is working on, what its plans are, etc.

• IP ownership: I’ve seen some investors push back on the idea as the company licensed some of the characters for Ragnarok. However, I don’t think this is that big of a risk. EA does not own the FIFA IP and has created a very valuable franchise.

Event Path

• August 9th, 2023 - Q2 earnings release – expect to see an acceleration of revenue/earnings from the Ragnarok Origin South East Asia launch (April 6th)

• November TBD - Q3 earnings release – expect to see continued momentum from prior game releases and from a worldwide launch of Ragnarok Origin.

Catalyst

Earnings inflection.