Description

(Note: share price is in ¥, market cap/enterprise value in US$, and EPS/earnings multiples are based on consensus estimates)

GungHo Online Entertainment develops and distributes internet and mobile games with over 90% of revenues coming from Japan.  The company’s market capitalization has gone from about $250 million a year ago to over $12 billion today on the back of its phenomenally successful mobile game Puzzles & Dragons.

I think GungHo presents an interesting short opportunity.  The company derives the bulk of its revenues from one game that has been unprecedentedly successful in a hit driven industry with short product cycles and low barriers to entry.  The company is valued at over 6x FY13e consensus revenues of ¥184 billion.  Prior to Puzzles & Dragons, this company was doing sales of about ¥10 billion.  Puzzles & Dragons is currently doing sales of about ¥11 billion per month compared to an industry norm for a successful game of <¥1.0 billion per month (a blockbuster is considered to be ¥2 billion).  Admittedly I do not have a strong view on the timing of the bust, but as I will explore later in the write-up I think it makes sense to short now. 

Mr. Morishita said he lives with a fear that people will stop playing the game and view the company as a flash in the pan amid the huge changes underway in the videogame industry.  “Boredom sets in, always,” he said. “You watch ‘Titanic’ over and over, and you will get tired…Who’s to say that the pendulum won’t swing back? Or swing in a completely different direction altogether. We are always in crisis mode.”  - WSJ article “How Nintendo Got Upended by ‘Puzzles & Dragons’”

Brief Background

GungHo was formed as a JV between Softbank and onSale in 1998.  In 2002 it changed its name to GungHo Online and switched from running SoftBank’s online auction business to specializing in PC and console games.  The company was listed in 2005.  It was best known for Rangarok Online, a MMORPG that accounted for 70% or so of company revenues until the release of Puzzles & Dragons.  The PC Online segment is currently in decline and is expected to continue to decline going forward given consumer shift to other gaming formats.  (GungHo owns 59.3% of Gravity, which has been written up on VIC several times before and has a market capitalization of about $30 million.)

The more important point here is that about two years ago, GungHo entered the mobile space and published about 10 games.  They have had some modest success, but nothing compares to the success they have had with Puzzles & Dragons.  

Puzzles & Dragons

Puzzles & Dragons is now by far the most important driver of company earnings, accounting for 95% of revenue in the month of April.  This hit has made GungHo the largest games app company in the world in revenue terms. 

Puzzles & Dragons is basically a Bejeweled-type puzzle game that is enhanced with RPG and collecting features.  Essentially you play a puzzle game but go through dungeons to battle foes and collect various items.  Puzzles & Dragons is reputed to be a pretty good game in terms of both concept (ie, more than just a card battle game) and functionality (ie, actually making use of the smartphone touchscreen).  Here is a trailer for the game: http://www.youtube.com/watch?feature=player_embedded&v=vgZFZtG8rQM

The game is freemium – free to download but monetized in other ways.  First, a player can pay to continue after a “game over.”  Second, there is a stamina bar that depletes as you enter dungeons, so a player can pay to completely recharge the stamina bar (otherwise the player has to wait a couple minutes as it recharges).  Third, players can pay to expand the capacity of their monster box to hold more monsters.  And fourth, they can spin the rare egg machine to get rare monsters.  

I estimate monthly ARPU of ¥1,000-¥1,100 in 4Q12/1Q13.  Not all users are active or pay, so the average revenue per paying user is on the order of ¥5,500 (ie, ~20% of users are paying).  Analysts estimate that approximately 50% of users are “active.”  

This has been a massive hit in Japan.  The iOS version of Puzzles & Dragons was launched on February 20, 2012 and became the top-grossing game in Japan in a matter of a few days.  In July 2012 it reached one million downloads.  The Android version was launched in September and became #1 in a week or so.  In October, total downloads reached two million.  Then the company launched a television advertising campaign which led to rapid growth.  On June 29, 2013, Puzzles & Dragons was downloaded for the 16 millionth time, translating to approximately 13% of the Japanese population.  For additional context, there were about 40 million smartphones in Japan at the end of 2012 (on roughly 130 million mobile subs).    

Aside from just its earnings impact, the success of Puzzles & Dragons has caused GungHo stock to rise dramatically because it validated GungHo as a good developer.  GungHo has taken a different approach to development and demonstrated significant success through a blockbuster hit without using the two biggest platforms in Japan (GREE and DeNA).  While most developers have gone the route of trying to maximize ARPU as fast as possible at the expense of DAU, GungHo has capped the ARPU on Puzzles & Dragons and tried to monetize more slowly in favor of a higher retention rate.  This has led to a retention rate of some 80% compared to an industry that does 20-30%. 

Short & Timing

The short call here is that as great as Puzzles & Dragons sounds today, people will get tired of lining up colored jewels and collecting digital monsters.  Most of these social/casual games peak in a few months.  Granted GungHo is trying to extend the life of Puzzles & Dragons by not over monetizing the game at the expense of DAU, but Puzzles & Dragons has been growing for an impressive 17 months now.  Just as Puzzles & Dragons was designed to hijack bored GREE/Mobage users, something else will come along and steal peoples’ attention. 

Remember that Puzzles & Dragons is 95% of the revenue here, and this game is generating monthly revenues of ¥11 billion compared to an industry norm for a successful game of <¥1.0 billion per month (a blockbuster is considered to be ¥2 billion).  For reference, the company’s next most successful game Princess Punt 2 is generating estimated monthly revenues of ¥350-450 million. 

I am recommending shorting ahead of the crack given the sheer size of the company, some very early signs of stress, and consensus estimates that now seem reasonable under status quo.

These might be famous last words, but I take comfort in shorting this today given the sheer size of the company.  One sell-side analyst thinks the installed base could approximately double to 30 million users.  That would mean almost three-fourths of current Japanese smartphone users would play Puzzles & Dragons (granted there will be some growth in smartphones).  Assuming the market cap likewise doubled, GungHo would be worth nearly $24 billion.  For reference, the combined values of Zynga, GREE, DeNA, Electronic Arts, Activision Blizzard, Take-Two, and Ubisoft are in the neighborhood of $27 billion.   

I also think now is the time to short given there are some very early signs of weakness here.  After establishing a record 41 consecutive weeks as Japan’s top grossing iPhone app, Puzzles & Dragons relinquished the top spot to LINE on June 21, 2013. LINE is an instant messaging app in Japan that is basically on every smartphone in the country.  It’s interesting because it does a lot (messaging, sending videos/pictures, gaming, etc) and users spend a lot of time in it.  Gamers can invite friends to play games on LINE, and LINE is asking for up to 50% take rates.  If LINE is successful in becoming the new de facto platform, even if GungHo achieves the unlikely task of producing another Puzzles & Dragons magnitude hit, the economics will be much worse if it is on LINE. 

Puzzles & Dragons is losing its popularity as measured by its download rank.  After fairly consistently being a top 10 game download on the iPhone in Japan during October through January, Puzzles & Dragons has steadily fallen to its current #19 spot.  Given the rankings are a bit volatile, it’s worth noting that #19 is toward the high end of its ranking over the last month (low end was #35).  The number of days it has taken to add a million users troughed at 15-16 days in late March/early April and it is now taking 21 days to add one million users. 

Lastly, I estimate that monthly revenues peaked in March and began to decline in April as the average daily revenue per user has fallen to ¥30 in April from ¥35-36 in 4Q12/1Q13.  After giving color on revenues in each of the first four months of the year, the company has not released any commentary about May revenues and has further suggested they do not plan to do so.  My skeptical take is that I wouldn’t either if revenues were declining at the same time I was enjoying my 15 minutes of fame. 

The final reason it makes sense to short now is consensus expectations are unlikely to see meaningful upward revisions given current trends.  There is only one sell-side estimate for 2Q13 revenues which is ¥45.5 billion.  Assuming it continues to take 21 days to add one million users, 2Q13 average users will be 13.9 million.  At an ARPU of ¥30/day, that equates to P&D revenues of ¥37.4 billion.  Adding ¥2 billion or so for non-P&D revenues (¥2-2.5bn over the last several quarters) would equate to ¥39.4 billion in revenues for a reasonably sized miss.  Granted that sell-side analyst appears to be the high for the year, so the real quarterly expectation might be closer to the ¥40 billion number.  If either the days it takes to add one million users continues to increase or the daily ARPU continues to decrease, the company will likely miss full year revenue expectations. 

Valuation & Return

The potential return to being short seems pretty large although I have not attempted to precisely sketch it out.  This company had a market cap of $250 million just 12 months ago, so if Puzzles & Dragons evaporated I wouldn’t be shocked to see the market cap revert to those levels. 

Other mobile/social gaming companies like Zynga, GREE, and DeNA have market caps or enterprise values in the $1-3 billion area.  Recent press articles have pegged the value of Rovio at around $4 billion or so.  All this compares to over $12 billion here.   

GungHo is currently trading at over 6x FY13e sales.  Zynga, GREE, and DeNA trade around 1.0x ttm revenues, while Electronic Arts, Activision, TakeTwo, and UbiSoft trade at 1.0-2.5x ttm revenues.  GungHo itself historically traded in a similar range.  Using peer multiples on FY13e sales of $1.8 billion would value GungHo at $1.8-4.5 billion.  Keep in mind that this sales number is likely unsustainable (they are generating revenues of 5x the #2 app). 

Let’s assume the April sales run rate for Puzzles & Dragons of ¥11 billion gets cut in half, equivalent to the company having half a dozen very successful games running at a time.  This would lead to full year mobile revenue of about $740 million.  Using the sales multiples above would lead to a value of $0.7-1.9 billion.  If we instead assume an incremental gross margin of 70% and that SG&A stays flat, this leads to operating profit of $400 million (54% operating margin).  At a 35% tax rate and assuming a 16x multiple, the company would be worth about $4 billion.  

Risks

The first obvious risk is that this is a company that has seen massive growth in a very short period of time which led to a meteoric rise in its share price.  While I am comforted by the fact that this is now a very large company, it’s always possible that Puzzles & Dragons continues growing and for subs to double or even triple and take the company’s shares with it.  Further, given this is a hit driven business where a few guys sitting in a room with a few million dollars can create something like Puzzles & Dragons, there is nothing to say the company couldn’t replicate its success again and perhaps before Puzzles & Dragons evaporates.    

GungHo is a consolidated subsidiary of Softbank.  Including the 18.5% holding of Masayoshi Son, Softbank owns 58.5% of GungHo.  SoftBank increased its stake in GungHo earlier this year.  The GungHo Chairman is Taizo Son, the younger brother of Masayoshi Son, and he owns 8.1% of the company.  So I would be cognizant of buyout risk here although GungHo has indicated that Softbank does not want to acquire the stake. 

Catalyst

• 2Q13 earnings are released July 29 - any negative data regarding Puzzles & Dragons
• Any continued deterioration in Puzzles & Dragons data (days to add a million subs, ARPU, etc.)