Description

Price: 11.0 HKD

Shares out (mm): 531

Market cap (mm): 5,870 HKD

Summary

I believe NetDragon botched an overly complicated reverse merger listing of its low-margin education business. Nonetheless, I feel this transaction will force the education business to self-fund, allowing increased shareholder returns from the remaining gaming business. I think the gaming business is a hidden gem with growth, high margins, and strong free cash flow generation trading at 2x 2024 EBITDA. Even as a combined entity, NetDragon returned ~50% of its current market capitalization to shareholders via buybacks and dividends in the past three years. I believe this will increase going forward.

Business Overview

NetDragon is a family business operated by the Liu family, who founded the company in 1999 and retain a 40% stake. Management appears to be well-regarded as first-generation tech operators and has successfully incubated other businesses. Notably, NetDragon sold 91 Wireless to Baidu for USD$1.9bn in 2013.

Today, NetDragon is a video game developer and internet company with headquarters in Fujian, China. NetDragon has two reporting segments: Gaming & Application Services and Mynd.ai.

Gaming & Application Services

Gaming accounts for 90% of Gaming & Application Services revenue.  Within Gaming, 90% of revenue is attributable to Eudemons, NetDragon’s flagship IP.

Eudemons is a first-generation MMORPG (e.g. World of Warcraft) that was released in China in 2006, where it was one of the first to adopt the free-to-play pricing model.  The game has been largely unchanged since its initial release but continues to benefit from a core user base that has remained loyal over the years while growing more affluent.  NetDragon primarily monetizes its users through an in-game currency and a loot box rewards system. 

Driven by Eudemons, Gaming revenue has grown at an 18% CAGR since 2015.  NetDragon self-publishes its PC games, leading to incremental gross margins in the high 90s.  Today, Eudemons maintains its status quo through periodic expansion pack releases, representing a cash cow business with minimal incremental costs.

Over the next two years, NetDragon is guiding for a comprehensive IP refresh that includes four new Eudemons releases as well as several additional titles.  This represents the first substantial update cycle for NetDragon’s flagship game.

The first of these releases is Eudemons Remake, which enters beta this quarter and is anticipated to be released by YE24.  Eudemons Remake is a remastered version of the current game, featuring upgraded graphics and a new gaming engine.  NetDragon believes the release will re-engage former players and improve the user experience for new gamers.  Management is guiding for this release to lead to a 10-15% revenue increase and has referenced other remastered game releases whose benefit has been considerably higher.

Further, NetDragon believes Eudemons Remake will increase attention to the IP ahead of a new Eudemons PC game, scheduled for release in 2025.  Two Eudemons Mobile releases are also being developed.

Mynd.AI (MYND)

Mynd.AI produces touch-screen interactive monitors for educational use in classrooms.  It primarily sells its displays under its Promethean brand, which has a 27% share in the US and 17% globally. 95% of MYND’s sales are from hardware, although management intends to continue to grow the proportion of revenue from software that runs on the device.

Management indicates revenues will return to growth in 2024 after declining 29% in 2023 due to a COVID-related bullwhip effect.  At its current $200mm TEV, MYND is valued at 0.5x sales.

Situation Overview

Due to a perceived undervaluation, NetDragon decided to pursue an independent listing of the education business. In December 2023, NetDragon completed a complicated reverse merger transaction resulting in Mynd.AI listing on the NYSE under the ticker MYND. NetDragon retained a 74% stake in MYND, so it is still consolidated in NetDragon’s financials. However, management expects this to be diluted over time as MYND raises additional capital. MYND has traded poorly since the listing and is valued at ~$200mm.

Valuation Analysis

Note: NetDragon reports in RMB, but trades in HKD, while Mynd.AI reports and trades in USD.

I estimate that NetDragon’s gaming business is valued at 2x EBITDA, which is cheap for a highly cash-generative and high-margin business with the ability to grow in the high single digits for the foreseeable future.

I value NetDragon using a sum of the parts analysis.

• I think the gaming business should trade at 8x EBITDA based on a 20% discount to comps (NetEase, Tencent, and Square Enix).
• I think the education business should trade at 0.8x TEV/sales based on a 10% discount to comps (Sonos, Vizio, and Sharp).

Capital Allocation

NetDragon pays semiannual dividends, which have been 0.40 HKD/share since 2021.  In addition to these two regular dividends, NetDragon paid a 1.00 special dividend in 2023.  The combined 1.80 HKD/share represents a 16% yield on today’s price.  In total, NetDragon has declared six regular and three special dividends since 2021, combining for 5.33 HKD/share – nearly half of the current stock price.

Additionally, NetDragon has repurchased 400m RMB of shares since 2021.  Buybacks were restricted during the execution of the MYND transaction but are now able to resume.

With MYND now able to raise capital from public markets instead of its parent, NetDragon should have additional cash available to return to shareholders.

Catalyst

Increased capital return.

New video game release cycle.

Mynd.AI recovery following the post-COVID bullwhip effect.