Description

Golfzon operates a dominant golf-simulator business in South Korea with ~80% domestic market share. The business generates a high-margin, recurring income stream from fees collected on the more than 50+ million rounds that are played on Golfzon simulators each year. The stock is cheap on trailing numbers, both relative to its own history and on an absolute basis (9x P/E, 8.4% FCF/EV, 6.0% dividend yield, with a 40%+ ROE), at a time when earnings are bottoming and a new product cycle is about to begin. Golfzon is in the process of launching its next generation golf simulator, and these launches have historically driven strong multiyear growth in hardware sales. The new simulator is being trialed with a small sample of site owners since August and a nationwide launch is imminent. We expect this product cycle to drive a 20%+ earnings CAGR between 2016-2020. Both the company’s earnings and the stock’s multiple have the potential to double over this period of time, making for a very attractive investment with strong downside protection supported by the high dividend and recurring fee income stream. Golfzon also has good corporate governance with one of the most attractive shareholder return policies in all of Korea.

Description / Background

Golfzon was founded in 2000 by Won-Il Kim, a former Samsung employee, along with his son Young-chan Kim (“YC Kim”). The company launched its first golf simulator (“GS”) in Korea in 2002 and gradually built a dominant market share of around 80%. There are a handful of smaller competitors, including Maum, GSwing, and SG Golf, which collectively hold the other ~20% market share.

The nature of the GS market in Korea is somewhat different than the simulators that golfers in other markets may be familiar with. Players in Korea typically play a full round of simulated golf on a GS rather than simply using it as a way to improve swing mechanics or as a substitute for a driving range. Numerous real world golf courses from Korea and overseas can be played on the Golfzon GS. While improving one’s real world golf game is often a motivation, players in Korea also play GS as a substitute for real golf, which is more costly and often more difficult to access, particularly for players in central Seoul. It is common for players to drink and gamble with each other during a game of GS.

Golfzon IPOed in May 2011 on the KOSDAQ stock market in Korea. In April 2015, Golfzon split into a Holding Company (“HoldCo”) and Operating Company (“OpCo”) through a spin-off transaction. The HoldCo is now called Golfzon Yuwon Holdings (121440 KS) and the OpCo is called Golfzon Co (215000 KS). The HoldCo took all of Golfzon’s non-GS assets (golf retail, golf courses, VR baseball) as well as a direct 20.28% stake in the OpCo. The OpCo became an asset-light business focused exclusively on the GS hardware and software business. This HoldCo / OpCo structure is common in Korea.

We are recommending an investment in the OpCo due to its cheaper valuation and superior ROCE and cash flow characteristics. We believe the spin-off was a positive development for investors as it allows a direct investment in the cash-generative OpCo without the drag from non-core, lower-return assets that management owns in the HoldCo.

Top shareholders in the OpCo are the HoldCo (20.28%), Won-Il Kim & YC Kim (31.57%), KB Asset Management (20.05%), and the Korean National Pension Service (6.62%). Ownership is very concentrated with management collectively controlling 53.61% of the shares, and 79.92% owned by management and the other top two holders.

Business Model

Golfzon manufacturers golf simulators and develops the operating software. Most of the components are sourced from sub-suppliers so Golfzon requires little capital to produce the simulators. The simulators are sold to independent third-party site owners, who install the simulators and charge customers a fee to use them. There are approximately 5,000 sites in Korea using Golfzon simulators today and approximately 25,000 simulators in use, so on average sites have about five simulators. Most site owners typically do not own many sites so Golfzon’s customer base is highly diversified. There are more than 1.8 million registered users in Golfzon’s online system out of a total golfing population in South Korea of approximately 3.2 million.

Golfzon collects revenues from the site owners in two primary ways. First, Golfzon sells new simulators to site owners. The last version of the Simulator, Vision, was sold for ~W50-60 million (US$45k-55k) although often if the site is upgrading an older version of the simulator, the upgrade cost is lower at around W20-30 million (US$18k-27k). After the simulator is installed, Golfzon charges the site owner W2,000 (US$1.80) for every 18 holes played by customers for use of the internet-enabled GS software system.

Site owners typically charge customers between W15,000 to W30,000 for eighteen holes (US$13.65 – $27.30), depending on the time of day and location (Seoul is usually more expensive than rural areas and evenings are usually more expensive than morning or midday times). Site owners can also generate additional revenue from selling food, beverages, and golf equipment (clubs, gloves, etc).

There will likely be some changes in the business model with the launch of the new simulator which will be discussed later in the write-up.

Corporate Governance

Corporate governance is always a concern in Korea, but we think Golfzon’s governance is good. The one possible gripe minority shareholders may have had in the past relates to the company’s “non-core” investments in golf courses and other low-return, golf-related assets. However, following the transition to the HoldCo, minority shareholders now have the opportunity to invest directly in the OpCo. We haven’t uncovered any other instances of minority shareholders being unfairly treated or abused by management.

There are some related party transactions between the OpCo and HoldCo, but these seem to us to be above-board, well-defined, and transparent. The OpCo pays 3% of revenue to the HoldCo as a royalty fee, and there are additional fees related to shared services (HR, IT, legal, etc) provided by the HoldCo which equate to approximately an additional 3% of OpCo revenue.

After the HoldCo/OpCo split, both entities began paying high dividend payouts. The OpCo paid a W4,000 per share dividend for 2015, which equated to a 67% payout ratio. We think the payout ratio for the OpCo is sustainable, and could even go higher over time. Golfzon has one of most rewarding shareholder return policies in the entire Korean market.

VisionTwo and Golfzon Park Franchise System

Golfzon has historically updated its GS hardware once every 4-6 years. The P-model was launched in January 2002, the N-model in January 2008, the Vision model in February 2012, and now the TwoVision in August 2016. The software is often upgraded between hardware launches. The Real software version was launched in January 2011 and the Vision+ was launched in January 2015. There is also new TwoVision software that is being launched with the TwoVision hardware.

The TwoVision system has several new features that are expected to enhance the GS experience. First, the new system has an additional screen on the floor between the player and the main wall-mounted screen which is used to simulate putting. Previously the system only had one screen on the wall. Second, the new system has higher caliber sensors which track the players swing from the front instead of from on top. This apparently makes the ball trajectory and spin more realistic. Finally, the TwoVision software adds a new Tour Mode, a play mode designed to be more accurate and challenging, which targets more advanced golfers.

TwoVision is currently being trialed at about 50 sites in two locations, Busan and one suburb of Seoul. Management believes the feedback on TwoVision has been very positive, with some site owners experiencing a sales uplift of 30%. Management plans to continue collecting feedback from site owners and users before an official nationwide launch later this year.

As part of the TwoVision launch, management is also launching a new franchise business model called Golfzon Park. In order to understand the reason management is migrating to a franchise system, some background on Golfzon’s sometimes tenuous relationship with site owners is necessary. When the screen golf industry was in a rapid growth phase between 2002-2013, many individuals rushed into the market to open new sites. After the market growth slowed, site owners located in inferior locations or areas that were oversaturated, experienced poor performance and sometimes losses. These struggling site owners often resorted to discounting the entry fee, which compounded the problem in oversaturated areas. Some site owners formed an association in 2013 and lobbied the National Assembly (Korean legislature) against Golfzon’s excessive power in the industry. With this pressure from the government, Golfzon agreed to stop selling new simulators for a one year period from April 1, 2014 to March 31, 2015, although they were still allowed to sell upgrades during this time.

Although the agreement has now lapsed and Golfzon is free to sell new simulators, management has been working on a strategy that will both improve the finances of most site owners as well as allow Golfzon to continue growing sales and profits. As a result, management decided to implement the Golfzon Park franchise system, which involves some tweaks in the business model. Golfzon will give existing site owners the option to enter into a franchise contract. Only sites that enter into the franchise contract will be allowed to buy the new TwoVision system. All sites which join the franchise system will agree to charge a fixed entry fee of W22k-25k in the morning/afternoon and W25k-W30k in the evening. Discounting this entry fee will not be allowed. Golfzon will also restrict new sites from opening within a specified radius of existing franchised sites. This should help address the key concerns of site owners. Sites that sign a franchise agreement will also be able to upgrade to the new TwoVision hardware at a much lower price of W10-15 million (about 50% lower than the W20-30 million upgrade price for Vision). In exchange for these benefits, new franchise sites will be required to pay an upfront franchise fee of W10 million, although this may be waived during an initial promotional period. Most importantly for Golfzon shareholders, Golfzon will increase the rounding fee charged per round from W2,000 up to W3,000. Some discounts on the W3,000 fee may be allowed for franchise sites with high volume of rounds played.

We expect that a successful transition to the Golfzon Park franchise model will be a big positive for the business and for the stock. Although the company will be sacrificing lower sales and profits on hardware due to the discounted price, this should be more than offset by higher software fees, which are both higher margin and deserving of a higher stock market valuation multiple. We also think that Golfzon Park has the potential to improve and strengthen the relationship with site owners.

Financial Performance and Outlook

Golfzon’s sales and profits have been under pressure over the past 18 months, hurt by declining hardware sales. This is entirely due to the product cycle, as Vision hardware sales have slowed and sales of the new TwoVision will only began to a limited extent in Q3 2016. In the most recent June quarter, sales declined 14% y/y and EBIT declined 10% y/y. Hardware sales were down by a more significant -57% y/y. We think that hardware sales have effectively hit a bottom at only W10 billion in the June quarter, down from peak past quarterly levels in the W50-60 billion range. Even with TwoVision selling at a lower price point , we expect hardware sales to gradually pick up in the next few quarters and double digit hardware sales growth should be sustainable for the next three years. Although it may not be reasonable to expect past peak hardware annual sales levels of W185b due to the business model change, getting back to W20-30 billion per quarter would still represent significant growth.

While hardware sales have been in the doldrums, software sales have continued to grow driven by rising rounds played. Software sales increased +15.8% y/y in the first half of 2016, all driven by volume. Not only has this helped to offset the decline in hardware sales, but we think it is clear evidence of the health of the overall business – end demand is healthy and growing. Although we do expect volume growth to moderate down to single-digits, ASP should start increasing next year as sites begin converting to the franchise model. We think it is reasonable to expect at least 3-4 years of mid- to high-teens software sales growth.

Historically before the HoldCo/OpCo split, Golfzon generated operating margins of 22-25%, but this included a drag from loss making businesses which are now in the HoldCo. We expect the OpCo to generate a margin around 25% in 2016 but we see significant upside over the next 3 years as hardware sales ramp up and the software ASP increases. A 30-35% operating margin seems very achievable.

The OpCo has wonderful cash flow characteristics, due to its minimal capex and working capital requirements. Free cash flow conversion was 99% in 2015 and we think 80-100% should be sustainable. The balance sheet is very strong with W30 billion of net cash (7.2% of market cap) at the end of June 2016.

Based on our forecast for rapid hardware and software sales growth driven by the launch of TwoVision and Golfzon Park, combined with improved operating leverage, we think earnings can double or more in the next three years.

Valuation

Golfzon trades at the bottom end of its own historical valuation range and on very cheap absolute multiples. The stock’s valuation on trailing twelve month numbers is 10x P/E (9x excluding non-operating items), 6.9x EV/EBIT, 8.4% FCF to EV, and a 6.0% dividend yield. Historically, the stock has traded at 9-17x trailing P/E and 5.5x-14x EV/EBIT.

Arguably, the OpCo should be awarded a higher multiple than the combined OpCo/HoldCo was in the past. Furthermore, the change in business model should lead to a significant mix shift toward software sales which we believe deserves a higher market multiple. During the last peak sales level for the GS business in 2014, approximately two-thirds of sales were hardware and one-third software. When the next peak level of sales is reached 3-4 years from now, we expect the mix to be reversed with about two-thirds of sales from recurring software fees. A 20x P/E multiple for a business with that type of revenue mix, market share, and cash flow conversion does not seem crazy.

We also note that the stock’s 6.0% dividend yield is one of the highest available in the entire Korean market.

Overseas Opportunity

Overseas markets could be an opportunity for Golfzon in the future, particularly the Chinese market. However we don’t expect any significant contribution from the overseas business in the next few years. Exports account for about 7% of sales but we don’t think the overseas operations are profitable. Golfzon has subsidiaries in China and Japan as well as distributors in other markets including the US, Canada, Hong Kong, and Taiwan.

Risks

Competition: The handful of smaller competitors with 20% market share offer seemingly similar products at a lower price point, which can be 10-50% cheaper than Golfzon simulators. Therefore, there could be a risk that these competitors capture some of Golfzon’s market share. While it is important to monitor competitor activity and market share, we are not too worried about Golfzon losing its dominance. Each competitor’s GS system has a slightly different feel and style of play. Our conversations with industry experts suggest that the majority of players are more familiar and comfortable using the Golfzon GS system. Players often play GS to compete with friends and sometimes gamble on the games. If a player is most familiar with and confident using a Golfzon GS, then he or she will be reluctant to use a competitor system. Furthermore, we think the new features included in the TwoVision simulator will further enhance Golfzon’s technological leadership vs. the competition for the next few years.

Site Owners: As discussed previously, Golfzon’s relationship with site owners has been tenuous in the past. We think this relationship has stabilized and has the potential to improve under Golfzon Park, but another public dispute with site owners could negatively impact the business and stock price. Furthermore, some site owners are suffering from poor financial performance. Management estimates that this is less than 20% of all site owners, but this is difficult to independently verify. If the reality is worse and many site owners are forced to exit the business or can’t afford to invest in simulator upgrades, this would negatively impact fundamentals.

Technological Risks: Virtual reality (“VR”) technology seems to have hit an inflection point and could become a mainstream product within the next 3-5 years. VR could create both opportunities and risks for Golfzon’s GS business. Management is already working on VR product development, and it’s easy to envision scenarios in which VR could really enhance the user experience in the successor version of TwoVision. But technology development is hard to predict and there is also a risk that new VR golf competitors emerge and pose a threat to the GS business model.

Catalyst

VisionTwo launch and earnings inflection point: With the OpCo stock price trading near its all-time low, we don’t think the stock has started to discount the upcoming new product cycle and strong multi-year earnings growth. We think the stock is likely to start re-rating when TwoVision is officially launched (imminently) and earnings growth emerges in the upcoming quarters.

Sell-Side Coverage: The HoldCo is currently covered by only one local broker and the OpCo is not covered at all. The new product cycle seems like an easy story to broke so hopefully a few more brokers will pick up coverage over the next year. Management says they have been having discussions with a few other brokers.

Bloomberg Numbers: Do to a quirk in Bloomberg’s data methodology, Golfzon’s 2015 and trailing twelve month numbers do not show up in equity screens. As a result, Golfzon is unlikely to be identified as a cheap stock in any Bloomberg screens other than on dividend yield. The reason is because the HoldCo/OpCo split happened in the middle of Q1 2015. Bloomberg doesn’t treat Q1 2015 as a reported quarter of data for the OpCo, and they also don’t treat Q4 2015 as a reported quarter because they can’t subtract a partial quarter from the full year numbers. Therefore, Golfzon won’t start showing up in equity screens on most financial metrics until the full year 2016 numbers are reported in March 2017. This could act as a catalyst as more investors begin to discover the stock.