Description

Nexon Investment Thesis - December 22, 2023

Nexon – The leader in Video Game Virtual Worlds is about to enter a major growth cycle

Nexon (~$11.4 billion enterprise value) is a multinational developer and publisher of live service video games, or “Virtual Worlds.” It is one of the best managed video games companies globally (consistently generating +30% EBIT margins while growing topline) and is a pioneer of deeply immersive multiplayer experiences. Nexon generates ~$3b in revenue from a robust portfolio of some of the industry’s most enduring and highest grossing franchises that continue to reach new record-breaking revenues. These include Nexon’s largest franchise Dungeon&Fighter (+$22 billion in life-to-date revenue), MapleStory (+$5 billion), KartRider (+$1 billion) and other major franchises like Sudden Attack, Kingdom of the Winds and Mabinogi (+$ 0.7 billion each). 

The stock market currently treats Nexon as essentially a “face in the crowd” of its video gaming peers. This is incorrect, based on three main assumptions: Nexon's current portfolio of Virtual Worlds is undervalued and offers a “floor valuation,” largely because the market underappreciated their “forever franchise” longevity. Even more importantly, and crucially for our thesis, the market completely misprices Nexon’s ability to expand its Virtual Worlds into Mobile platforms (Fig. 1 emphasized in blue). Finally, we see strong potential in Nexon's pipeline over the next 18 months, as it has one the most promising pipelines of new intellectual property (IP) among all public video game companies. We are not only optimistic about the potential of this pipeline, but also confident in Nexon's ability to successfully realize it, owing to Nexon's strategic positioning and expertise in relation to the Artificial Intelligence (AI) Revolution – a long-wave macro trend shaping the global entertainment landscape.

These three assumptions form a foundation for margin expansion and earnings surprises to the upside over the next 18 months. We believe Nexon today offers a over +2.4x upside to reach our long-term intrinsic value estimate of ~$28B enterprise value (Fig. 1), with several catalysts that can close this valuation gap, the most important being the platform expansion (Fig. 1 emphasized in blue) of its current Virtual Worlds.

Figure 1. We believe that Nexon offers 2.4x upside

Source: Skycatcher

Our first assumption is that Nexon's current “Virtual Worlds” will continue their steady growth, making them the company’s solid foundation and providing a “valuation floor” for our investment thesis. 

Nexon was founded in Korea in the 1990s when it created the first graphic massively multiplayer online role-playing game (MMORPG) Kingdom of the Winds, which still runs today. The company later created the first free-to-play game, Quiz Quiz. After experimenting in many segments of the video game industry, Nexon decided to focus on the segment of the industry that it understood the most, and saw the biggest growth opportunity in, which is deeply immersive online Virtual Worlds (see Appendix 1 for more detail on Nexon’s positioning in the interactive entertainment industry). 

The majority of Nexon's current revenue stems from three primary Virtual Worlds: Dungeon&Fighter, MapleStory, and FC Online. We estimate that in 2023, Nexon's top six franchises will account for 65% of its total revenue (Fig. 2) and that these franchises will have experienced a compound annual growth rate (CAGR) of 11% from 2014 through 2023, the same rate of growth as Nexon’s total topline. 

Video gaming investors tend to focus on a company’s pipeline of new titles as the main source of future growth. However, there is an elite tier of existing “forever franchises” within the industry that stand out for their longevity over long periods of time. These forever franchises not only offer much more sustainable cash flows than the average title, but they are also better able to capture the secular growth tailwinds (demographics, cultural acceptance, globalization) that the gaming industry structurally enjoys.  

Because the “sustainable same-store sales growth” attributes of forever franchises play out over time, they are often deeply underappreciated by the stock market. Nexon has a diversified stable of several existing forever franchises, which makes it unique compared to most game companies. Taking into account their well-deserved “longevity premiums,” Nexon’s existing Virtual Worlds, on their existing platforms, are by themselves worth more than the entire current enterprise value of the company.

Figure 2. We estimate that Nexon generates about 65% of its revenue from its top 6 franchises, which have experienced a combined 11% CAGR over a sustained period (2014 – 2023e)¹.  

Source: Nexon’s Financial Statements, Skycatcher’s Estimate for 2023 

When Nexon builds Virtual Worlds, their key defining feature is longevity. We believe there are two key factors that have driven the lasting appeal and continued growth of these franchises: 

1. Nexon’s franchises are deeply immersive online multiplayer experiences that differ widely from traditional games and are more akin to theme parks (see Appendix 2 for more detail on Virtual Worlds vs. Traditional Games). 

Nexon’s Virtual Worlds resemble niche social networks, sustained by a dedicated community of players who form active friend networks within these worlds. The importance of fun and differentiated gameplay paired with deeply social experiences can best be seen in Nexon’s two leading franchises, Dungeon&Fighter² and MapleStory³.  These games are not distinguished by cutting-edge graphics, and may look very simple on the surface. But they are designed to be experienced almost like a “second life,” with continuous milestones and no fixed endpoint (Fig. 3). 

Figure 3. Nexon’s games are designed to be like a “second life.” The graphic below shows two players in MapleStory getting married. 

Source: MapleStory

2. Nexon’s expertise in running content updates and balancing virtual economies (live operations or LiveOps) is industry-leading.

Successful long-term LiveOps means the ability to manage content updates thoughtfully in the context of the complex virtual economies that emerge from Virtual Worlds. This becomes increasingly more challenging through time, as each of these worlds have their own in-game currency and in-game resources which must be balanced to ensure there isn’t hyperinflation of virtual items or other factors which burn out player motivations. Nexon’s expertise in LiveOps is prominently showcased through the achievements of MapleStory, its second-largest Virtual World. 

MapleStory is a testament to longevity in gaming. As it reaches its 20th year, this MMORPG is deeply integrated into Korean culture⁴ and continues to grow (Fig. 4). One of the key areas that Nexon has mastered is continued improvements in operational efficiency and user engagement.⁵ Nexon’s expert live operators have played a key role in growing Korea MapleStory at a 16% CAGR since its inception in 2003. 

Figure 4. MapleStory may break a new annual revenue record as it completes its 20th year in operation.⁶

Source: Nexon’s Financial Statements, Skycatcher’s Estimates 

Dungeon&Fighter (D&F), Nexon’s largest franchise, has been in operation for 18 years and is still the highest grossing PC game in China (Fig. 5).⁷ 

Figure 5. Dungeon&Fighter is the highest grossing PC game in China. 

Source: Goldman Sachs, Skycatcher Estimates 

Since its inception in 2007, China Dungeon&Fighter has grown at a 20% CAGR and hit a peak in 2018. After 2018, the franchise declined following content updates that weren’t well received by the player base. But we believe D&F is now entering a new growth cycle (Fig. 6). In 2021, a decision was made to bring Myeong-jin Yun on board to oversee the development and Live Ops for the PC version of D&F, including its services in China. This move was strategic, aimed at injecting a fresh creative vision and reigniting growth in the game. Yun is recognized for his influential role in the franchise's significant growth from 2014 to 2017. His innovative approach to content has been instrumental in re-engaging the player base. With Yun’s return to a leadership role, the China version of PC Dungeon&Fighter has shown signs of stabilization and early indications of a fresh new growth trajectory. 

Figure 6a. China PC D&F has stabilized with oversight from Myeong-jin Yun, and is starting to show early signs of recovery.⁸

Source: Nexon’s Financial Statements, Skycatcher’s Estimates 

Figure 6b. For the first time we see growth in DNF’s Baidu Peak Search Index score during this year’s National Day Update. 

Source: Baidu Index  

Figure 6c. China PC Dungeon&Fighter showed robust growth during its last Lunar New Year update (which launches annually in Q1). We expect this growth to continue into next year. 

Source: Nexon, Skycatcher  

MapleStory and Dungeon&Fighter have experienced significant growth, to roughly 19 times their original size since launch. Their progress, while fluctuating at times, shows a consistent upward trend over long periods. This long-term view reveals undeniable expansion despite short-term volatility. Moreover, at Nexon’s portfolio level, it has 6 current Virtual Worlds which together show steady growth and counterbalance any fluctuations of an individual franchise. Over the last decade, this portfolio of Virtual Worlds has grown at a +11% CAGR, a record that underpins the portfolio’s role as the “floor valuation” to our thesis. The key takeaway is that Nexon’s current Virtual Worlds have “forever franchise” longevity which distinguishes them from less stable or shorter-lived video games, and gives long-term investors a solid foundation for compounding growth.

Our second assumption is that the platform expansion of Nexon's Virtual Worlds to Mobile offers massive earnings growth potential, with surprisingly high predictability, in the coming 1 to 2 years. 

Nexon’s Virtual Worlds had their start on PC, and while some of these franchises have expanded to Mobile, PC still represents 70% of total revenue (Fig. 7). We think there is still a big opportunity for Nexon to expand its Virtual Worlds on Mobile, not only through growing its existing Mobile Virtual Worlds, but also through new extensions of its existing PC Virtual Worlds to Mobile. 

Figure 7. Nexon generates 70% of its revenue from PC, with significant room to expand its Mobile revenue. 

Source: Nexon’s Financial Statements, Skycatcher’s Estimates 

Nexon’s Virtual Worlds originated on PCs capable of playing massively multiplayer online games (MMOs). The problem was that not many people had access to game-ready PCs. And while many people had access to mobile devices, those devices couldn’t run Virtual Worlds. Today that’s different, with mobile phones from the iPhone 10 and up (and its Android equivalent) being fully capable of rendering deeply immersive, complex Virtual Worlds. This platform convergence⁹ means Nexon has a significant opportunity to greatly expand its Total Addressable Market (TAM). Unlike the past, where Nexon's audience was limited to several hundred million PC gamers, the current market includes billions of mobile phone users capable of accessing complex virtual worlds. This represents a tenfold expansion in Nexon's TAM (Fig. 8). 

Figure 8. Mobile represents a 10X increase in Nexon’s Total Addressable Market 

Source: Nexon Letter to Shareholders FY2021, Skycatcher’s Estimates 

The possibility of expanding into the Mobile market represents a significant opportunity for Nexon. This is particularly true since many of its most enduring Virtual Worlds have not yet been introduced to Mobile platforms in their main markets (Fig. 9). 

Figure 9. Three of Nexon’s six biggest Virtual Worlds haven’t yet expanded to Mobile in their core markets, including Nexon’s biggest Virtual World, Dungeon&Fighter. 

Source: Nexon’s reports 

The most prominent game in Nexon’s Mobile pipeline is Mobile Dungeon&Fighter (mD&F), which has already seen success in Korea but awaits its launch in China, Dungeon&Fighter’s largest market. China mD&F represents the largest untapped revenue opportunity for Nexon’s existing portfolio of Virtual Worlds. 

We anticipate that the launch of mD&F in China will be a pivotal evolution for the franchise. It is one of the most highly anticipated games in China, having reached over 60 million pre-registered users before the game was delayed and removed from mobile app stores in August 2020 because of changes in China’s video game regulations. 

The release of China mD&F is inevitable, and we believe it can more than triple the size of Nexon’s Dungeon&Figher franchise (Fig. 10a) and double Nexon’s total operating profit¹⁰ (Fig. 10b). With Tencent as the publisher in China, Nexon is poised to earn substantial royalties from the title. Our current estimates suggest that mD&F will garner $4.3 billion in gross bookings. We estimate the deal will give Nexon a 28% royalty takerate¹¹ which translates to $1.2 billion in net revenue accruing to Nexon’s topline. We estimate Nexon’s royalty income will boast an EBIT margin of 90%, and thus mD&F can add $1.08 billion in operating profit. Despite the magnitude of these predictions, they are surprisingly reasonable when we consider how many leading IPs in China have already more than tripled their revenue with the launch of their respective Mobile extensions (See Appendix 3). 

Figure 10a. The launch of mDNF in China could more than triple China D&F. 

Source: Skycatcher’s Estimates

Figure 10b. And expand Nexon’s total operating profit by +2x. 

Source: Skycatcher’s Estimates 

Our current gross revenue estimate for mD&F would place it as the new second highest grossing game in China's mobile game market. However, we think this is a conservative estimate, especially when considering the current market trends. Presently, League of Legends, which ranks as the number two game on PC in China, holds the title as the highest grossing mobile game in China¹². Additionally, CrossFire, the third highest grossing PC game, has a mobile counterpart that is the second highest grossing mobile game in China¹³. This pattern indicates a clear trend where leading PC games not only successfully transition to the Mobile platform, but also export their dominant positions in the PC market to the mobile space (see Appendix 3). 

Given that Dungeon&Fighter is currently the top grossing PC game in China, it stands to reason that its mobile version could potentially rise to the number one spot in the mobile gaming market (nearly doubling our current estimate and resetting the mobile rankings to reflect what we see in the PC market). However, our assumption only positions mD&F at the number two spot on mobile, reflecting a cautious approach despite the evidence it has the potential to achieve even greater success.

However events unfold, we expect China mD&F to rank among the top 3 games in China's mobile gaming market, which implies a range of $2 to $8 billion in annual revenues. This is a wide range of possible financial outcomes, but it gives us comfort that there’s notable upside to our current estimates (see Appendix 4 for more details on the range of potential outcomes). 

Our third assumption is that Nexon is leading the AI Revolution in the video game industry. We will see the impact of this leadership in Nexon’s pipeline of new games, which could lift an already high-quality company to top-tier status with a globally diversified portfolio of Virtual World franchises.

The foundation of Skycatcher’s investment philosophy in the gaming sector is the identification of longevity, which we define as the capacity of existing intellectual property to remain relevant and financially significant over a decade or more. This is always the first step in our search for risk-adjusted outperformance, and it’s the first step in our Nexon investment, since the company’s track record and approach to nurturing and expanding its existing IPs exemplify what we look for. 

But it is not only Nexon’s current portfolio of franchises that we are excited about. Over the next 18 months, Nexon will release multiple new Virtual Worlds on the back of AI-driven approaches to game development.

About four years ago Nexon established Embark Studios with the core team who built the successful Battlefield franchise. The goal of Embark was to employ machine learning and AI tools to unlock new emergent game experiences while also dramatically reducing the cost and time to ship AAA quality games. This approach solves two major issues that have been affecting the AAA video game industry: 1) The cost to develop AAA games is rising quickly and is unsustainable; 2) Because of this, AAA game companies are taking low-risk bets which isn’t good for game customers, developers, or investors (see Appendix 4 for more commentary). 

Embark, however, is revolutionizing the industry by drastically reducing game development costs and speeding up the creation of AAA shooter games. This strategic approach enables Nexon to enter the western AAA shooter market without jeopardizing its current high-profit operation. On the 3Q2023 earnings call (Fig. 14), Nexon CEO Owen Mahony highlighted Embark's success in developing “The Finals” with a lean team of less than 100 people at peak, a stark contrast to the typical AAA game which can reach up to 500 and even 1,000 people. This approach challenges the industry's conventional model.

Figure 14. From Nexon’s 3Q 2023 earnings call, on the power of using AI in game development. 

Source: Nexon 3Q 2023 earnings call

In The Finals, AI is used in its Matchmaking Logic¹⁴ and the game employs AI-generated voice¹⁵. The most groundbreaking aspect, however, is Embark's rapid content creation capability. Utilizing advanced tools, Embark can generate a 1x1 km multiplayer map in just one month, dramatically cutting down a process that typically takes 2 years (Fig. 15). This considerable increase in efficiency is crucial for meeting the rapid consumption trends of contemporary gamers and will revolutionize live service operations. 

Figure 15. Embark can develop game content far faster than a traditional AAA studio. 

Source: Nexon’s presentation “The Future – It’s Bigger and Weirder than You Think –” by Nexon CEO Owen Mahoney 

Building on the efficiency of Embark's AI tools in The Finals, what stands out is not just the speed of asset development but also the remarkable improvement in quality and fidelity. Embark's ability to create larger, more detailed worlds in a fraction of the usual time, and with a much smaller team compared to traditional AAA studios, is a game-changer. 

We’ve been closely following Embark ever since its inception, as well as the two titles it has nurtured: The Finals (launched 7 December 2023) and ARC Raiders (anticipated to launch 2H2024). Both titles bring new experiences to the shooter genre, and we see early signals of them turning into successful franchises. Rather than focusing on only visually impressive or narrative-driven games, Embark has focused on developing fundamentally fun and differentiated games with unique gameplay systems. This strategy echoes that of successful games like Minecraft, Roblox, and Fortnite, which diverged from traditional models and became immensely popular due to their innovation (see Appendix 5 for more details). 

In The Finals, the key attraction is the game's server-side destruction. The entire map is destructible and alters in real time based on players’ actions. This unique feature ensures that each game unfolds differently, offering dynamic and unpredictable gameplay. As the map continuously evolves, it prevents players from mastering a static environment, leading to fresh and unforeseen gaming experiences every time (Fig. 11). 

Figure 11. The Finals with its server-side destruction provides infinite replayability.

Source: The Finals

Since its launch, The Finals has already reached +240k peak players on Steam and has been ranking in the top 10 most played games on the platform over the last few days (see Appendix 6 for more details on The Finals’ traction). 

Embark Studios is also advancing game system design, notably with its upcoming title "ARC Raiders." This game, a PvPvE (Player vs Player vs Environment) multiplayer survival extraction shooter, represents a potentially monumental leap in AI-driven gaming. We believe Embark is utilizing technologies like AI Locomotion and AI Enemies – technologies that the company has been vocal about working on (See Appendix 7 for more detail)¹⁶. These technologies are truly revolutionary, but getting them to work in a way that is “fun” for the player is something that Embark has still been figuring out. 

When we look at these new IPs, we think there is a strong chance that they can become a hit in the genre (+$400m in revenues¹⁷) or even a global blockbuster (+$1 billion in revenues with potential to range up to +$5 billion¹⁸). Considering that the shooter genre is one of the most lucrative in gaming, and that these titles bring unique and fresh gameplay experiences to the genre, we think there is a strong chance that Embark Studios can reach +$800 million in revenue by 2025. 

Embark’s success for Nexon will yield material diversification advantages. Embark's games are designed mainly for a Western audience and for consoles—a new platform for Nexon—we anticipate that their AAA game pipeline will enhance Nexon's diversification (Fig. 12)

Figure 12. Nexon could see significant revenue diversification across regions and platforms through the realization of Embark’s games.  

Source: Nexon’s Financial Reports, Skycatcher’s Estimates

We believe the north star to finding the next big winners in video games will be those companies that fully leverage an AI-driven approach to game development. AI minimizes risk through lower development costs while maximizing potential returns by enabling quicker iteration and more diverse project development. This synergy between customer satisfaction, developer creativity, and capital efficiency is a powerful flywheel that is only just getting started in the video game industry—and Nexon is at the forefront.

We believe that Nexon is currently trading below the “floor valuation” provided by its current Virtual Worlds alone; that it has a relatively predictable platform expansion opportunity hiding in plain sight; and that it offers one of the industry’s most compelling pipelines.

We value Nexon by breaking down its assets into three parts: its existing popular “Virtual Worlds”; the “Platform Expansion” of its Virtual Worlds, especially mD&F; and its upcoming pipeline. Currently, Nexon is valued at about $11.4 billion, which we think is less than the value of its current Virtual Worlds ($14.2 billion). In other words, we’re not only getting Nexon’s Current Virtual Worlds at a discount, but also the Platform Expansion of its Virtual Worlds ($11.4 billion) and a promising pipeline of upcoming games ($3 billion) for “free.” When we calculate Nexon's intrinsic value using this method, we estimate it's worth around $28 billion, more than double its current market value (Fig. 16). 

Figure 16. Nexon offers 2.4x upside to our intrinsic value estimate. 

Source: Skycatcher

Firstly, looking at Nexon's portfolio of existing games, we expect it to grow by about 6% annually over the next three years and continue to generate ~40% operating margins (since Nexon counts the cost of developing new games as research and development expenses, we added back these costs (i.e. treating them more like growth capex) to understand the true profits from its current games). Considering the high margins Nexon’s portfolio of Virtual Worlds generates and the robust growth we expect from the portfolio over the long term, we believe a multiple of 17x EV/NOPAT is reasonable (see Fig. 18 for additional context). We apply this 17x EV/NOPAT multiple to our 2024e estimate of $835 million in NOPAT to arrive at our intrinsic value estimate of Nexon’s current portfolio of Virtual World games at $14.2 billion (Fig. 17). 

Secondly, for the platform expansion of Nexon’s Virtual Worlds, we focus on valuing China mD&F (the main catalyst for platform expansion), which we estimate will earn about $1.2 billion in annual royalty income with a 90% pretax profit margin. We apply a 15x EV/NOPAT multiple of on our 2025e NOPAT estimate of $760 million, giving us a value of $11.4 billion. 

Finally, for Nexon's pipeline of upcoming Global IP, we expect the two games from Embark discussed above to bring in a combined $870 million in annual revenue by 2025e with a 50% operating profit margin. In assessing Nexon’s game portfolio, we recognize that existing, enduring games with proven longevity merit a distinct valuation approach. But we cannot attribute this same longevity factor to a pipeline. Therefore, given the inherent uncertainty surrounding their ultimate long-term success and staying power, we apply a 10x EV/NOPAT multiple on 2025e estimated NOPAT of $305 million for these IPs—giving us a value of $3 billion. 

Figure 17. Nexon sum-of-the-parts Valuation¹⁹

Source: Skycatcher Estimates 

Nexon is also cheaper than similar gaming companies when we look at other financial metrics. With Nexon's focus on efficient game development (like using AI in Embark's games) and a major game in the pipeline that generates almost pure margin royalty income (Mobile China Dungeon&Fighter), we think the company's operating profit margins will expand from 34% in 2023 to 43% by 2026.²⁰ Furthermore, we expect the company to grow operating profit at a 27% CAGR between 2023 and 2026. Today, the market only expects Nexon to grow its operating profit by 7% CAGR, which we believe vastly underestimates the potential of platform expansion of its current Virtual Worlds and pipeline (Fig. 18). 

Figure 18. Nexon is deeply mispriced compared with peers. 

Source: S&P Capital IQ, Skycatcher’s Estimates  

Despite multiple catalysts on the horizon, a capital allocation tailwind from significant share count reductions (see Appendix 8), and a base of existing franchises which continue to exhibit robust growth, Nexon trades at only 11x enterprise value to consensus FWD EBITDA, below its median multiple of 13x over the last three years (Fig. 19).

Figure 19. Nexon trades at 11x FWD EV/EBITDA vs. its historical three-year median of 13x. 

Source: S&P Capital IQ, Skycatcher’s Estimates  

Risks 

• The primary risk for Nexon is negative reception of any future major content updates to its existing Virtual Worlds. This could be reception related to the quality of the content itself, game balance implications, or monetization implications. A bad content update can lead to a downturn in the game. With MapleStory, Nexon has been able to quickly respond to negative feedback, but it’s possible that some issues may take longer to correct. We track these updates and user receptions closely (Fig. 19). 

Figure 19. We use multiple tools to track several metrics on Nexon’s games in their core markets 

• Continued delay to Mobile Dungeon&Fighter, i.e. a launch later than 2025. 

• Continued regulations and restrictions imposed on the Chinese Video Games industry. On 22 Dec 2023, Chinese regulators announced a wide range of draft regulations aimed at curbing spending and rewards that encourage video games. It's important to note that these are currently proposed measures and not yet implemented, indicating that they are subject to further review and modification before potentially becoming official. This stage in the regulatory process allows for industry feedback and potential adjustments based on various stakeholders’ input. That said, China is not done with setting restrictions and it remains a risk. Some of the proposed regulations include: 

  •  Online games must set spending limits

  •  Online games must ban daily login rewards

  •  Players who stream their games must not be able to receive large tips

  •  Probability-based luck draws must not be offered

  •  Online game approvals must be processed by regulators within 60 days of publishing

In September 2021, Chinese regulators imposed restrictions on game time for under-18s and we think some of the above restrictions may be targeting this demographic. However, less than 1% of Dungeon&Fighter’s player base is under 18, which shields the company from these risks (Fig. 20). If these regulations are imposed on older age groups, we believe the risk is highest from whale-driven titles. Dungeon&Fighter has a democratized monetization model, again mitigating this risk (Fig. 21). 

Figure 20. Less than 1% of Dungeon&Fighter’s user base is under the age of 18. 

Source: 3Q2021 Earnings Transcript 

Figure 21. Nexon’s franchises are not whale-driven 

Source: 4Q2022 Earnings Transcript 

Conclusion 

Our Nexon thesis is underpinned by three main assumptions:

1. Its current Virtual Worlds give us a “floor valuation” because they have “forever franchise” longevity 

2. The platform expansion of its biggest Virtual World, Dungeon & Fighter, will drive major earnings growth in the next 1 to 2 years

3. Nexon is leading the AI revolution in games which, allows it to further diversify globally and by platform, and to introduce new innovations

These assumptions drive our view that Nexon is materially undervalued, with most of this value coming from major platform expansion of its existing current Virtual Worlds. We believe the path to closing the gap in valuation will be a combination of earnings growing faster than consensus (we expect +40% EPS CAGR vs. consensus of +10% over next 2 years) and valuation multiple expansion over time as more investors grow to appreciate the nature of its quality. 

Looking out longer term, Nexon’s management team gives us comfort that the company is increasing its competitive moats. Since 2014, Nexon has been led by Owen Mahoney, who spearheaded a disciplined framework of risk / reward in game development, investments into AI tools years ago, and most recently the beginnings of building transmedia IP.²¹ During Owen’s tenure, Nexon’s stock price has generated a 21% IRR.²² 

Nexon pioneered video game Virtual Worlds, and over the last 20 years has shown it can drive growth sustainably through this unique model of deeply immersive online experiences. Now, Nexon is about to enter a new growth phase on the back of platform expansion for its largest franchise and a rich pipeline leveraging the power of AI-driven game designs. All together, Nexon’s management team, its scale and know-how in live service games, and its record of strategic decisions give us conviction it is a leading candidate for the top performing video game company in the decade ahead. 

Appendix

Appendix 1: Nexon’s positioning in the interactive entertainment industry. 

Nexon uses a four-quadrant framework to conceptualize the video game industry. This framework is structured with two axes: the x-axis differentiates between offline and online games, while the y-axis distinguishes between immersive (deep) and casual gaming experiences. This model isn't about ranking or valuing different types of games. Rather, it simply serves to classify them, and thereby better understand Nexon's strategic positioning within the industry. Historically, the industry began with immersive single-player offline games, mainly on consoles and PCs, located in the upper left quadrant. 

The advent of the internet heralded the expansion into the right side of the graph, which includes online games. This shift began in the mid-90s, particularly in Korea and China, with the innovation of online gaming and the free-to-play (F2P) model. Approximately 15 years ago, the emergence of Facebook and smartphones revolutionized the lower half of the quadrant, popularizing casual games.

Nexon's main strength and historical focus lies in creating deeply immersive online games, also known as Virtual Worlds, which fall into the upper right-hand quadrant. It’s this area that Nexon believes has the most growth moving forward. It also has the fewest number of competitors that can make and operate these kinds of games. These Virtual Worlds offer highly immersive experiences, and connecting thousands of players simultaneously and operating them over decades requires a highly specialized skillset. Previously, such games were exclusive to PCs, but advancements in mobile technology have now made these Virtual Worlds accessible on most smartphones (see Assumption 2 for more details on Nexon’s “platform expansion” opportunity).²³

Nexon is focused on deeply immersive online Virtual Worlds.  

Source: Nexon Letter to Shareholders FY2020

Appendix 2: Virtual Worlds vs. Traditional Games.  

Nexon distinguishes itself in the video games industry by prioritizing the creation of Virtual Worlds, in contrast to the traditional gaming model. Traditional games are comparable to Hollywood blockbusters, offering short-lived, high-growth cycles post-launch, then fading predictably. These traditional games have a linear development and consumption phase – they are packaged to ship as final products and consumed over a short period, and typically only once. 

Virtual Worlds, by contrast, are akin to theme parks. They represent a sustainable model, capable of indefinite growth and enduring for decades. They are continuously developed and constantly updated with fresh content that is designed to keep players coming back. This allows Nexon to keep adding to its Virtual Worlds and growing them, rather than having to come up with new experiences to replace the old. Similarly, this means that they don’t need to replace old revenue with new, but instead simply augment their growing established franchises with new ones. 

Traditional Games are linear in their production and consumption whereas Virtual Worlds exhibit continuous development and consumption, the length of which can run into the decades. 

Source: Nexon’s 3Q2012 Investor Presentation 

Virtual Worlds exhibit fluctuating revenues, user engagement, and average revenue per paying user (ARPPU) in the short term, but trend upward over the long term when managed effectively. Furthermore, Virtual Worlds exhibit content leverage,²⁴ meaning a single piece of content can be consumed multiple times. Put differently, one hour of content development can result in multiple (even indefinite) hours of content consumption. For this reason, Virtual Worlds have the potential, when run effectively, to sustain high margins over long periods. Thus, Virtual Worlds have the potential to provide a durable high-margin recurring revenue stream.

Nexon’s Virtual Worlds are capable of indefinite growth and endure for decades, compared to Traditional Games which exhibit a boom-and-bust lifecycle. 

Source: Nexon Letter to Shareholders FY2020

Appendix 3: Previous IPs that have more than doubled from their expansion to Mobile. 

We have observed numerous games in China that originated on PC and later grew materially after their expansion to mobile. The two case studies below are from leading PC games in China that expanded to Mobile. The first is League of Legends (the number 2 PC game in China by our estimates). And the second is Fantasy Westward Journey, which we believe is the number 3 or 4 top grossing PC game in China. We believe these two case studies are most suitable for mD&F since all three are leading PC games in China, which we believe to be the simplest and most predictive factor when estimating the success of mobile platform expansion. Looking at the charts below, one can imagine what will happen when China’s number one PC game expands to mobile. 

League of Legends expanded its revenue by more than fourfold following its expansion to Mobile. Furthermore, we observed no cannibalization of the PC game. In fact, PC grew, suggesting a synergistic launch.

Source: Goldman Sachs, Skycatcher Estimates – Mobile for League of Legends refers to Honor of Kings 

Fantasy Westward Journey expanded its revenue by more than threefold following its expansion to Mobile. Again, we observed no cannibalization of the PC game. In fact, PC grew, suggesting a synergistic launch. 

Source: Goldman Sachs, Skycatcher Estimates 

A third case study is PeaceKeeper Elite, which “expanded” by more than sixfold following its expansion to Mobile. Here we use CrossFire revenue for PC. Based on our understanding, CrossFire is the leading PC shooter game in the Chinese market. PUBG PC in China is likely less than CrossFire, which means the multiple of expansion would be higher if we used PUBG PC. These of course are not the same IP. 

Source: Goldman Sachs, Skycatcher Estimates 

What’s even more impressive about the above examples is that they have maintained a strong position in China Mobile, with Honor of Kings (the mobile equivalent of League of Legends) remaining the highest grossing Mobile game, PeaceKeeper Elite remaining the #2 game on Mobile, and Fantasy Westward Journey remaining in the top 5 highest grossing mobile titles. 

Below we share some additional examples from the Korean market. We think these further show the impact that expanding to mobile has. 

Lineage expanded its revenue by more than threefold following its expansion to Mobile. In this case, the mobile launch had some cannibalization effect on PC, but still the impact of mobile on total franchise earnings far outweighed the cannibalization. 

Source: NCSoft Financial Reports  

Black Desert Online expanded its revenue by more than threefold following its expansion to Mobile. In this case, the mobile launch didn’t appear to have a cannibalization effect on PC. 

Source: Pearl Abyss Financial Reports , Skycatcher Estimates 

MapleStory expanded its revenue by more than double following its expansion to Mobile. In this case, the mobile launch certainly did not cannibalize PC revenue. But in this case, it appears the mobile launch may have mostly had a catalytic effect on PC. Since 2015 was near the lows for the franchise, the mobile release may have even revived interest in the IP by making it available to a broader audience. Furthermore, MapleStory M has some cross-play functionality with its PC counterpart.²⁵

Source: Nexon Financial Reports , Skycatcher Estimates 

Appendix 4: There is a wide range of potential outcomes for Mobile China Dungeon&Fighter 

We anticipate that Mobile Dungeon & Fighter will quickly become one of China's top three mobile games, which today generate between $2 billion and $8 billion in gross revenues. If we consider a “number two” or “number one” game scenario, we foresee mDNF generating $4 billion and $12 billion in gross revenue, respectively. Assuming a constant royalty rate, such a performance could more than triple the total net revenue for the franchise. 

Since Tencent is the publisher, Nexon’s Mobile Dungeon&Fighter revenue is a royalty income (~90% margins) that could double total franchise revenue. 

Source: Data.ai, Skycatcher’s Estimates 

As the income from mD&F is primarily high-margin royalty revenue, a more successful outcome would significantly enhance Nexon's profit margins. In our “#2 Game” and “#1 Game” scenario, we project that operating profit margins could reach 41% and 44%, respectively, reflecting the substantial incremental margin accretion from mD&F's success. 

Nexon’s margins range of outcomes

Source: Nexon’s Financial Statements, Skycatcher’s Estimates 

Again, the above assumes a constant royalty rate of 28%, the mid-point of guidance (21-35%). A higher royalty rate would not only significantly boost net revenue from the game, but also total operating income for Nexon considering the extremely high flow-through to earnings from this royalty stream. 

Appendix 4: AAA gaming is in trouble  

The cost to develop AAA games has been rising rapidly over the last decades and it’s reaching a point that is unsustainable. These increases in costs are also typically related to improvements in graphical fidelity rather than actual gameplay – fun, and immersive games. 

The average cost of developing an AAA video game has doubled every 5 years since 2010.  

Source: Raphkoster.com, Nexon’s presentation “The Future – It’s Bigger and Weirder than You Think –” by Nexon CEO Owen Mahoney, Skycatcher’s Estimates 

The above charts are averages. That said, AAA games can now run over $300 million and even $1 billion in development costs. The main problem with this is that game developers now rely more on taking less risky bets such as sequels and remakes to avoid a very painful “flop”. This is clearly bad for game customers who want new creative surprises and game developers who don’t want to “remake” the same game. 

It doesn’t just end with game creators and customers. The rising costs of AAA game development is also bad for investors. The conservative strategy AAA game studios are taking, while safer, caps the potential upside. Embark's use of AI disrupts this paradigm, effectively improving the risk / reward profile of game development. By reducing production costs and accelerating content creation and iteration, AI lowers the risk of investing in new IPs, while simultaneously unlocking the considerable potential rewards that emerge from fresh, creative innovations. 

Appendix 5: Fun and Differentiation in Games  

A key aspect of the philosophy of Nexon and Embark is their focus on fun gameplay, and interactivity is essential to achieving this. The goal is to create experiences that challenge the player and require players to make decisions and work with others. Their philosophy for creating engaging and fun games is maintaining a "Flow" state for players. There are many factors that lead to “Flow,” such as cooperation (multiplayer experiences), immediate feedback and others, but for games the most prominent is “challenge tuned to players’ ability.” A game that is too easy can lead to player boredom, while a game that is too hard can lead to player frustration. A game that is boring or frustrating for players leads to churn. 

But in a “Flow” state, players can become completely engrossed in what they’re doing. Keeping players in the “Flow” state for longer drives player retention. For example, in The Finals, Embark uses AI to analyze keyboard and mouse movements, identifying a player's skill level within seconds, and uses this information in their Matchmaking Logic.

A game is fun when the player is in a state of “Flow.” 

Source: Nexon’s presentation “Can Investors Moneyball the Game Industry?” by Nexon CEO Owen Mahoney 

Embark and Nexon’s focus is to create games that are both “Fun” (i.e. keeps players in the “Flow” state) and differentiated – the upper righthand corner of the chart below. These games tend to stick around for a long time. Games that are fun but lack differentiation tend to have a fast-follower approach (the black oval), meaning they take a game mechanic that works and copy it. Games that are neither fun nor differentiated fall in the red oval. Hit games (and usually those that go on to become genre-defining or carve out a unique segment within a genre) tend to be both fun and differentiated. These games tend to also have long-run success and establish a dedicated audience. 

Nexon and Embark are focused on creation both fun and differentiated games.  

Source: Nexon’s presentation “Can Investors Moneyball the Game Industry?” by Nexon CEO Owen Mahoney 

Appendix 6: Traction of The Finals   

The Finals has already reached +240k all-time peak players on Steam. 

Source: SteamDB

Appendix 7: AI locomotion and AI Enemies represent a potential monumental leap in video game Non-Player Character (NPC) design  

Moving away from traditional animation methods like motion capture, AI and machine learning are capable of simulating character movements. This advanced technique allows characters to learn and adapt their movements based on their physical attributes like shape and weight distribution. Characters can teach themselves to walk, climb, and perform other actions in a realistic manner. AI locomotion is not just a fancy tech demo; it also has the potential to create a whole new level of immersion in gameplay. 

Similarly, AI is revolutionizing enemy behavior in games. Instead of relying on pre-scripted attack patterns, AI-driven enemies can strategize ways to win. This adaptive approach means that enemies can attack in unpredictable, non-scripted ways, continually challenging players and preventing gameplay from becoming repetitive or predictable. Both these technologies aim at creating highly emergent gameplay. 

Appendix 8: Long-term optionality in Embark’s ambitious mission to “blur the line between playing and making.”

Embark envisions a gaming industry where games are more accessible, catering to a wider and more diverse audience, and more collaborative, with online and social components playing a larger role. They aim to enhance interactivity by allowing players to shape their gaming experiences. This concept is already evident in industries like fashion, where consumers can become influencers, and in music, where anyone can publish a song or podcast in seconds, as well as in online content creation platforms like YouTube and TikTok. However, creating high-quality interactive content in gaming still demands professional development skills, making it an exclusive field.

Currently, user-generated content in gaming is limited. For instance, on platforms like Roblox, only a small fraction of players are creators. Embark's ambitious goal is to transform over 80% of their players into creators. Recognizing the need for significant changes in game development, they plan to utilize their proprietary AI-driven tools and technology stack to facilitate this. Their creator platform, Creative Playground, is set to launch for testing in the upcoming year.

As investors, we understand that realizing this vision is a long-term endeavor. The gaming industry's evolution towards greater user participation and content creation presents significant challenges. However, there is considerable long-term potential in Embark's strategy. If they successfully democratize game creation, enabling a vast majority of players to become creators, it could redefine the gaming landscape. 

Embark wants to turn more than 80% of players into game makers. 

Source: Nexon’s presentation “The Future – It’s Bigger and Weirder than You Think –” by Nexon CEO Owen Mahoney 

Appendix 8: Corporate Governance and shareholder return 

Nexon holds a substantial $4.6 billion in cash and cash equivalents, constituting about 25% of its market capitalization. The company views its balance sheet as a stronghold, aiming to create a resilient business capable of enduring any economic conditions. Nexon's strategy is to avoid relying on external funding for mergers and acquisitions or resorting to employee layoffs. Instead, they focus on strategies to accelerate their growth. With a deep understanding of their niche in Virtual Worlds, their robust cash reserves allow them to act swiftly and compete effectively for lucrative opportunities, even against larger companies with more substantial cash reserves, such as Amazon or Microsoft.

A case in point is Nexon's past attempt to acquire Riot Games, which occurred before Nexon went public. At the time, Nexon was outbid by Tencent due to insufficient funds. This missed opportunity highlights the significance of having ample financial resources, suggesting that with more capital or if Nexon had been public at the time, the outcome might have been different. 

Despite its philosophy of maintaining a fortress balance sheet, Nexon has been active in returning cash to shareholders via both dividends and share repurchases. We think Nexon’s significant share repurchases indicate management’s belief that their business is undervalued, and we anticipate that share repurchases will continue to play an important role in shareholder return. 

Nexon has been actively reducing its total share count through regular share buybacks. 

Source: Nexon’s Financial Statements, Skycatcher’s Estimates 

Endnotes

1.  We use a constant currency exchange rate of 142 JPY per USD. We use this same rate across the rest of the investment memo.

2.  DNF stands out with its unique 2D side-scrolling and arcade-style gameplay, differing from typical multiplayer action-RPGs. DNF also excels in its gameplay with an easy-to-learn, hard-to-master accessibility, action-packed combat, and iconic, pixelated art. 

3.  MapleStory’s ongoing evolution, deep player engagement, and character customization options have contributed to its enduring success. 

4.  Player registrations in Korea equal 45% of the country’s population. 

5.  For instance, AI helps identify potential player churn by analyzing certain player behavior like reduced chat activity or boss fights, enabling a proactive response with tailored incentives tuned to a player’s ability. Source: Nexon’s presentation “IT’S A TRAP!!! - How to Invest in Video Games without Getting Blown up” by Owen Mahoney, NEXON CEO

6.  We use a constant currency exchange rate of 1,300 KRW per USD. We use this same rate across the rest of the investment memo. 

7.  Outside of Tencent published games, we believe Netease’s Fantasy Westward Journey may rank within the top 3 but does not exceed the revenue from Dungeon&Fighter. 

8.  We use a constant currency exchange rate of 7.14 RMB per USD. We use this same rate across the rest of the investment memo. 

9.  Source: Nexon’s presentation “The Future – It’s Bigger and Weirder than You Think –” by Nexon CEO Owen Mahoney 

10.  When compared to total group operating profit over the last twelve months. We assume mDNF will launch in 2025 to be conservative, but it may launch sooner. 

11.  This rate is the midpoint of the 21-35% range advised by Nexon's Investor Relations Team. 

12.  The mobile equivalent of League of Legends is Honor of Kings 

13.  CrossFire is the leading PC shooter game and we refer to PeaceKeeper Elite as its mobile “counterpart.” PeaceKeeper Elite’s direct equivalent would be PUBG on PC. 

14.  In The Finals, Embark uses AI to analyze keyboard and mouse movements, identifying a player's skill level within seconds, and uses this information in their Matchmaking Logic. Nexon's 32 AI-driven live service technologies are key in tuning game challenges to player skills, essential for engagement and retention. Given the high cost of user acquisition, it's vital to keep players interested to avoid financial loss. 

15.  AI-generated voice enables rapid voice modifications during development, eliminating the need for voice actors. 

16.  Nexon’s presentation “Revenge of the Nerds” by Owen Mahoney, NEXON CEO

17.  Comparable to APEX Legends 

18.  Comparable to Call of Duty which does $2b to $3b. Games like Fortnite top +$5b in some years. 

19.  Our NOPAT figures are for the respective periods of selection, e.g. for Pipeline NOPAT refers to 2025e. Instead of applying a target multiple for that time and discounting the value back to the present, we utilize a multiple of forward earnings. In the case of Pipeline it’s two years out, Current Virtual Worlds is one year out, etc. 

20.  Nexon used to generate a 39% operating profit margin in 2018, when PC China Dungeon&Fighter was a bigger part of total revenue. 

21.  In January 2022, Nexon made a strategic minority investment of $400m in AGBO, known for directing several of Marvel's Avengers movies. Furthermore, Nexon has established a film and television division in Los Angeles, which is led by Nick van Dyk, a former Disney and Activision-Blizzard employee. Van Dyk serves as the president of Nexon Film and Television and is also the Executive Vice President and Chief Strategy Officer (CSO) of Nexon. This is part of Nexon’s strategy to make the next 20 years of its franchises bigger than the last.  

22.  Measured from March 2014 and on a JPY-basis. 

23.  Source: Q4 2019 Earnings Presentation (February 13th, 2020) CEO Message by Owen Mahoney

24.  Source: Nexon’s presentation “The Old World is Gone” by Owen Mahoney, NEXON CEO

25.  MapleStory M and MapleStory (PC) have features that allow for a form of cross-play, but they are not fully integrated for seamless cross-platform play. Players with a character level 60 or above in MapleStory (PC) can link their account to MapleStory M. This linking allows players to complete daily missions in either game and earn rewards for the other game. For example, you can assign your highest level MapleStory character to MapleStory M's Legion Synergy Grid, and completing daily missions in one version of the game can earn you rewards in the other version. Additionally, there are crossover events where players can participate in activities that involve both versions of the game. These events often include daily missions, rewards, and special activities that bridge the two games. LINK, LINK, LINK. 

Catalyst

• New shooter games primarily from Embark
• Mobile D&F China launch