| 2009 | 2010 | ||||||
| Price: | 0.95 | EPS | $0.00 | $0.00 | |||
| Shares Out. (in M): | 28 | P/E | 0.0x | 0.0x | |||
| Market Cap (in $M): | 27 | P/FCF | 0.0x | 0.0x | |||
| Net Debt (in $M): | -40 | EBIT | 0 | 0 | |||
| TEV (in $M): | -13 | TEV/EBIT | 0.0x | 0.0x | |||
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Gravity has turned profitable but continues to trade below net cash of $40+ million.
Gravity was written up on VIC at $5.85 per share in December 2006 and at $4.25 per share in August 2007. The company was losing money at that time, as the flagship game Ragnarok Online was in decline while no new games of any significance had been marketed. Fast forward to today: The share price remains under $1, significantly below net cash per share, while the company has turned profitable on cost cutting and new game releases. The highly anticipated release of Ragnarok Online 2 remains delayed, but at the current valuation and based on recent operating performance, RO2 has become a potential windfall rather than a necessity.
The Hard-to-Believe Reality
Gravity is one of Asia's top developers of Internet-based games. Results have turned solidly profitable following the appointment of a new CEO in June 2008. Based on our analysis, the company may have earned more than $3 million dollars of adjusted operating income in Q4 2008, suggesting an operating income run-rate of approximately $14 million (more on this later). The company has more than $40 million of cash, no debt, and is once again growing revenue in the double-digits on the back of new game releases. Could a growing company with high returns on capital command a valuation of 10x estimated operating income, i.e., $140 million? Adding $40+ million of cash, might Gravity be worth $180 million?
Mr. Market, recently under the tremendous stress of what some have termed a stock market "meltdown," appears not to have found the time to reevaluate his harsh opinion of Gravity. You see, Mr. Market had punished Gravity for delaying repeatedly the release of a much-anticipated game-and for the resulting operating losses. Now that Gravity has turned the corner in a big way, has Mr. Market revised his opinion? Not one bit, judging by the dismal multiple he is still putting on our estimate of Gravity's adjusted operating income: minus one. That's right, forget about arguing what multiple Mr. Market should pay for Gravity. The company still trades for less than net cash!
Some Background on the Hard-to-Believe Reality
Gravity went public on Nasdaq on the back of the hugely successful game Ragnarok Online, one of Asia's first and most popular massively multiplayer online role-playing games (MMORPGs). The company raised $71 million at $13.50 per share in 2005. The same year, a Japanese company affiliated with the large tech company Softbank bought out Gravity's founder, paying close to $25 per share, or roughly $350 million, for his 52% stake in the company. In 2008, the majority holder bought another 7% of Gravity, bringing the stake to 59%.
We wouldn't be discussing Gravity here if everything had gone smoothly since the company's IPO in 2005. The highly anticipated release of Ragnarok Online 2, the sequel to the company's best-selling game, has been delayed repeatedly, causing revenue to decline and development costs to increase, producing operating losses. The deteriorating fundamentals led investors to scrutinize several other aspects of Gravity, including the company's lacking corporate governance and even fraud committed by former officers (now long resolved). U.S. activist hedge funds Ramius Capital and Moon Capital sued the company in South Korean courts and won certain concessions on governance matters. It appears that the company's responsiveness to U.S. investors has improved recently. Ramius and Moon own 10% and 9% of Gravity, respectively, giving them a continued interest in seeing shareholder value maximized.
Today, Gravity's stock price of roughly $1 per share, does not appropriately reflect recent positive developments. The positives include the release of new games, including Emil Chronicle and Requiem, even as Ragnarok Online 2 remains in open beta testing and has yet to be commercialized. Most of all, however, Gravity's value has been enhanced by the cost-cutting actions taken by new CEO Yoon Seok Kang. Together with resurgent revenue growth, the cost reductions have led to sharp increases in operating income.
Why Investors May Have Missed Gravity's Solid Profitability
A quirk in Gravity's reporting schedule makes it difficult to appreciate the extent of the company's recent profitability. Gravity does not report consolidated results for the year ended December 31st until it files Form 20-F in June. The company files non-consolidated results in a 6-K filing in early April, but those results are based on Korean GAAP and do not correspond to the quarterly reports filed by the company. Long story short, we still don't know for sure what Gravity's Q4 results looked like. However, we have pieced together an estimate of the Q4 results based on historical consolidated and non-consolidated financials.
The bottom line: It appears that Gravity earned adjusted operating income of 4.5 billion Korean Won, or $3.4 million, in Q4. For a reconciliation of consolidated and non-consolidated results and our estimate of Q4 results, download our Gravity financial model.
A Look at the Potential Upside
To get a sense of the upside once Mr. Market awakens to the fact that the Gravity enterprise has some value, let's look at what the company might be worth:
|
Low Estimate |
High Estimate |
|
|
Excess Cash Value |
||
|
Non-consolidated net cash at yearend 2008 |
$41 million |
$41 million |
|
Cash required to run business |
-$10 million |
-$1 million |
|
Excess cash |
$31 million |
$40 million |
|
$1.12 per share |
$1.44 per share |
|
|
Earning Power Value |
||
|
Estimated normalized EBIT |
$4 million |
$14 million |
|
Fair value multiple of normalized EBIT |
8x |
10x |
|
Value of Gravity enterprise |
$32 million |
$136 million |
|
$1.15 per share |
$4.89 per share |
|
|
Total Equity Value |
||
|
Estimated fair value |
$63 million |
$176 million |
|
$2.27 per share |
$6.34 per share |
|
Source: Company data, our estimates and analysis.
We judge Gravity to have strong downside protection due to (1) $40+ million of net cash, exceeding market value; (2) a business that has turned profitable and cash flow positive; (3) significant stock ownership by activist hedge funds Ramius and Moon, who have taken action to protect shareholders in the past; (4) the possibility of a bid by the majority shareholder to buy out the minority holders; and (5) a high return-on-capital business with favorable long-term growth prospects.
Some Questions and Answers on Gravity
Q: Gravity's valuation seems too good to be true. Is there anything you worry about here?
A: We have two primary concerns. First, we worry that Gravity may be delisted from Nasdaq, opening the door for the majority shareholder to try to buy out the minority holders on the cheap. Gravity does not currently meet Nasdaq's $1 minimum bid requirement, nor does the company have three independent directors on the Board's compensation committee (two of the three members are currently "independent"). While Gravity is in discussions with Nasdaq to remedy this deficiency, and while the stock price appears likely to surpass the $1 bid requirement, there is no guarantee that the shares will remain listed on Nasdaq.
Second, we worry that recent profitability might be a fluke. Gravity does not have a history of consistent profitability, and it is impossible to know whether the recent positive trend will persist. If the company reverts to operating losses, the cash balance could be eroded over time.
Q: Ragnarok Online 2 still has not been released. Do you have any idea when this might happen?
A: It's impossible to predict when RO2 might be released-and in what form. Thankfully, the company's other games have already propelled it to profitability and growth. As a result, we view the future release of RO2 as an added bonus rather than a necessity. It appears likely that RO2 will be commercialized in 2009.
Q: How do we know that Gravity really has $40+ million of cash in the bank? Could it be a fraud?
A: We are usually highly skeptical of Asian microcap companies listed in the U.S. However, in Gravity's case, we know that the games are "real" because they are available online. In addition, two large U.S. hedge funds have known the company for years and even litigated against it in Korean courts. We also know that the company raised $71 million in an IPO on Nasdaq in 2005. Finally, the financial statements are audited by a Hong Kong-based member firm of PricewaterhouseCoopers.
Gravity Links:
Disclosure: We own a long position in Gravity and may dispose of some or all of our shares at any time without further notice. This writeup does not constitute an investment recommendation or investment advice. As always, please do your own work before investing.
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