Description

 

Idea

 

Gravity (GRVY) was the subject of a insightful VIC write-up in December 2006.  At the time, the stock represented a great value with a terrific risk reward.  Since that time, the stock has declined almost 30% from $5.85 to approximately $4.25.  We believe this decline was driven by the general carnage in small cap land during the recent (hopefully finished) correction and a large shareholder selling (GRVY trades approximately 15,000 shares a day, so a big seller is very damaging).  But the catalyst for the stock, the release of the Ragnarok 2 (R2) multi-player online game, is now only months away.  Our due diligence on the game post the December write-up (see below) indicates that R2 is a solid game with an eager fan base.   And the valuation has only become more compelling.  The stock was cheap at $5.85; it is incredibly cheap at $4.25.  With almost $3 per share in net cash, GRVY would trade at only 1x earnings if R2 matches the earrings of the original game.  If the game is merely half as successful as its predecessor, it would trade for a 2 P/E ex-cash.  I don’t see many of those available in the market.  We believe there is approximately $1 in downside (trades to net cash) and upside of 3x or more.

 

Background / Activism

 

GRVY, based in Korea, produces the MMORPG (massive muli-player online role playing game) Ragnarok as well as a few other less important titles.  The original Ragnarok was a ground breaking game that became a smash hit in Asia.   Players participate with others in a world based on Norse mythology where the fight monsters and achieve great powers.  It can be a highly addictive hobby (see recent Wall Street Journal and New York Times Magazine articles on the subject).  The game reached its peak earnings (over $1 per share) in 2004 and the Company went public in 2005 at $13.50.  

 

The stock declined soon thereafter and has become an activist battleground.  In August 2005, EZER, an affiliate of Softbank, purchased Gravity’s former Chairman Kim Jung Ryul’s 52.4% stake in the company for an estimated $24.70 per share or 3.5x its then trading price of $7.10.  EZER declared in an SEC filing that it had acquired the stake in GRVY to secure a continued licensing deal for the Ragnarok game.  EZER further stated that it would not pay over $7.10 per share for the remaining shares in GRVY, threatened to have the Company delisted from the NASDAQ, and raised the possibility of using its voting power to force the sale of all the Company’s assets.  These strong-arm tactics resulted in a shareholder backlash.  Ramius Capital and Moon Capital, hedge funds with a combined $8 billion in assets under management and a 16% stake in GRVY, have taken the lead in protecting minority shareholders. 

 

We believe corporate governance has improved significantly over the last few months.  The Company has become much more responsive to investors.  Management has begun hosting earnings calls, shareholder meetings and doing road shows in the US. 

 

The Company is set to release R2 over the next few months in Korea and across Asia (its primary markets) with the US and Europe to follow. 

 

 

Due Diligence

 

We have retained consultants who work at a game development firm and are affiliated with departments at academic institutes that study gaming.  They have played the beta (which was in Korean) and surveyed online chat sites.  They have reported that the game appears to be a solid sequel, with improved graphics, interesting characters and good music.  While the beta had some technical glitches (not unusual), the chat sites indicate it has been very well received. 

 

We have also found numerous references to the game on the internet.  YouTube has 2,800 trailers and clips from the beta.  Considering that YouTube is more US/Western oriented and Ragnarok is primarily an Asian phenomenon, this seems to indicate good buzz.

 

While no due diligence can guarantee the game is a smash hit (or even a success), our findings point to a well received product with an excited fan base. 

 

Financial Analysis

 

GRVY has a market capitalization of approximately $120m.  The Company has over $80m in cash and short-term investments (approximately $3 per share) giving it a TEV of only $40m.  The Company is currently losing money as it is between game cycles.  So it has trough revenues coupled with elevated expenses for development.  However, the losses are not especially big (net loss of $1m for Q1 2007, the last quarter reported) and cash has actually grown due to upfront licensing fees.  At the Q1 burn rate, the Company has 20 years of cash in the bank giving us confidence it should not trade below net cash even if the game fails.  At its peak, Ragnarok earned over $1.20 per share and generated approximately $40m in EBITDA (so a P/E less cash of approximately 1x and a TEV / EBITDA of approximately 1x).  Even with conservative assumption on the games success (only earns $.25 for example), the stock is cheap.

 

 

Idea

 

Gravity (GRVY) was the subject of a insightful VIC write-up in December 2006.  At the time, the stock represented a great value with a terrific risk reward.  Since that time, the stock has declined almost 30% from $5.85 to approximately $4.25.  We believe this decline was driven by the general carnage in small cap land during the recent (hopefully finished) correction and a large shareholder selling (GRVY trades approximately 15,000 shares a day, so a big seller is very damaging).  But the catalyst for the stock, the release of the Ragnarok 2 (R2) multi-player online game, is now only months away.  Our due diligence on the game post the December write-up (see below) indicates that R2 is a solid game with an eager fan base.   And the valuation has only become more compelling.  The stock was cheap at $5.85; it is incredibly cheap at $4.25.  With almost $3 per share in net cash, GRVY would trade at only 1x earnings if R2 matches the earrings of the original game.  If the game is merely half as successful as its predecessor, it would trade for a 2 P/E ex-cash.  I don’t see many of those available in the market.  We believe there is approximately $1 in downside (trades to net cash) and upside of 3x or more.

 

Background / Activism

 

GRVY, based in Korea, produces the MMORPG (massive muli-player online role playing game) Ragnarok as well as a few other less important titles.  The original Ragnarok was a ground breaking game that became a smash hit in Asia.   Players participate with others in a world based on Norse mythology where the fight monsters and achieve great powers.  It can be a highly addictive hobby (see recent Wall Street Journal and New York Times Magazine articles on the subject).  The game reached its peak earnings (over $1 per share) in 2004 and the Company went public in 2005 at $13.50.  

 

The stock declined soon thereafter and has become an activist battleground.  In August 2005, EZER, an affiliate of Softbank, purchased Gravity’s former Chairman Kim Jung Ryul’s 52.4% stake in the company for an estimated $24.70 per share or 3.5x its then trading price of $7.10.  EZER declared in an SEC filing that it had acquired the stake in GRVY to secure a continued licensing deal for the Ragnarok game.  EZER further stated that it would not pay over $7.10 per share for the remaining shares in GRVY, threatened to have the Company delisted from the NASDAQ, and raised the possibility of using its voting power to force the sale of all the Company’s assets.  These strong-arm tactics resulted in a shareholder backlash.  Ramius Capital and Moon Capital, hedge funds with a combined $8 billion in assets under management and a 16% stake in GRVY, have taken the lead in protecting minority shareholders. 

 

We believe corporate governance has improved significantly over the last few months.  The Company has become much more responsive to investors.  Management has begun hosting earnings calls, shareholder meetings and doing road shows in the US. 

 

The Company is set to release R2 over the next few months in Korea and across Asia (its primary markets) with the US and Europe to follow. 

 

 

Due Diligence

 

We have retained consultants who work at a game development firm and are affiliated with departments at academic institutes that study gaming.  They have played the beta (which was in Korean) and surveyed online chat sites.  They have reported that the game appears to be a solid sequel, with improved graphics, interesting characters and good music.  While the beta had some technical glitches (not unusual), the chat sites indicate it has been very well received. 

 

We have also found numerous references to the game on the internet.  YouTube has 2,800 trailers and clips from the beta.  Considering that YouTube is more US/Western oriented and Ragnarok is primarily an Asian phenomenon, this seems to indicate good buzz.

 

While no due diligence can guarantee the game is a smash hit (or even a success), our findings point to a well received product with an excited fan base. 

 

Financial Analysis

 

GRVY has a market capitalization of approximately $120m.  The Company has over $80m in cash and short-term investments (approximately $3 per share) giving it a TEV of only $40m.  The Company is currently losing money as it is between game cycles.  So it has trough revenues coupled with elevated expenses for development.  However, the losses are not especially big (net loss of $1m for Q1 2007, the last quarter reported) and cash has actually grown due to upfront licensing fees.  At the Q1 burn rate, the Company has 20 years of cash in the bank giving us confidence it should not trade below net cash even if the game fails.  At its peak, Ragnarok earned over $1.20 per share and generated approximately $40m in EBITDA (so a P/E less cash of approximately 1x and a TEV / EBITDA of approximately 1x).  Even with conservative assumption on the games success (only earns $.25 for example), the stock is cheap.

 

Catalyst

GRVY has dropped to a ridiculously cheap level due to the overall sell-off in small cap stocks and likely pressure from a large seller. Its large cash position protects the downside from here. While it has had corporate governance issues in the past, the presence of big activists and a new attitude by the Company and some key new executives has helped make this less of an issue. The launch of R2 provides an immediate catalyst. If the Company can earn $.60 from the game (50% peak earnings from the original) and trades at 10x EPS, the stock would be at $9 (10x $.60 + $3 in cash) for a return of over 100%. If the Company can duplicate the success of the prior game (admittedly difficult due to greater competition, though we believe current licensing deals are superior to the previous game and a new micro transaction model could generate higher revenues) the stock could at a big price and provide a massive return from here. NCSoft (a Korean MMORPG) trades at 16x 2008 estimates ex cash and The9 (a Chinese MMORPG) trades at 15x 2008 estimates ex cash. A similar valuation on GRVY, assuming it hits peak earnings, would yield a stock price of over $20.