Description

I recommend purchasing shares of Nexon. The company is not well-known to most Western investors (and gamers) but is the owner of two of the most popular video game IPs in Asia. While shares are down ~50% since May, I believe the stock has been oversold on temporary headwinds and the fears surrounding China’s “video game crackdown”. For long-term focused investors, Nexon’s current valuation offers an attractive entry point with over 100% upside and several upcoming catalysts, while its balance sheet provides significant downside protection with cash and investments totaling to ~45% of the company’s market cap.

Executive Summary

- Declining monthly active users (MAUs) overshadows a more stable paying-MAU base that is increasingly spending more in Nexon’s virtual worlds.

- Nexon was unarguably late on the shift to mobile but has found its footing with Maple Story M and others, laying the groundwork for similar success with Dungeon Fighter Mobile in China.

- Reports of PC gaming’s death are greatly exaggerated. Mobile is where the growth is, but PC isn’t shrinking.

- Beyond Dungeon Fighter Mobile, Nexon has several other upcoming catalysts over the next ~18 months that could change the growth trajectory of the company and it doesn’t need to bat 1.000.

- Seasonal updates create volatility but also opportunity.

- First-rate management focused on the right things.

- Attractive valuation relative to global peers.

Company Overview

Nexon is a ~$10bn Korean video game developer that is listed in Japan. By market cap, it is the 3^rd largest game developer in Korea and the 14^th largest publicly traded video game company globally. It specializes in massive multiplayer online (MMO) games, and is credited with pioneering the free-to-play (F2P) model used by some of today’s biggest games such as Fortnite, Destiny, Genshin Impact, etc.

A bit of background on the gaming industry in South Korea may be helpful to understand Nexon’s business model. South Korea was one of the first countries to build out high-speed broadband starting in the 90s. Today nearly every home in South Korea has high-speed internet access vs. ~25% in the US. In this environment the video game industry developed differently than it did in the West. While in the West the industry evolved from single-player experiences on consoles like Xbox and PlayStation, in South Korea it is rooted in online shared experiences via PC (and eventually mobile). The most successful games in South Korea have been determined more by online social dynamics and communities rather than innovative gameplay and storytelling like in the West. In Nexon’s games, players typically create online identities and share experiences with other players in Nexon’s online worlds. The games are free to download and play, while Nexon’s revenues are derived from players choosing to purchase virtual items in the games. Most of the time these virtual items do not offer any advantage over other players and are more of game status symbols in these virtual worlds. As players invest more of their time and money in one of Nexon’s virtual worlds, they become more unlikely to abandon their chosen game for another. Over the years this has helped create a more predictable baseline of cash flows from hardcore players in Nexon’s most popular games.

Nexon’s two most popular franchises are Dungeon Fighter Online and Maple Story, which combined account for over 50% of revenue. While these games may be unfamiliar to investors as well as gamers in the West, they are extremely popular in Asia. Dungeon and Fighter was first released in 2005 and is the 7^th highest grossing video game franchise of all time, while Maple Story was released in 2003 and it’s the 40^th highest grossing game. To equate this for western investors, the list of highest grossing franchises of all-time above Dungeon Fighter consist of Activisions’s Call of Duty and a collection of household names that have been around for 20+ years like Pokémon, Super Mario, and Pacman, while Maple Story is sandwiched between Nintendo’s Super Smash Bros. and EA’s Battlefield franchises.

Beyond Dungeon Fighter and Maple Story, Nexon is responsible for several other successful franchises in Asia. Most notably, KartRider (a Mario Kart competitor), FIFA Online (a F2P version of EA’s FIFA in Korea), and Mabonigi.

Investment thesis:

Declining MAUs are overshadowing a more stable paying playerbase that continues to increase spend. While Nexon’s MAU, pay rate, and average revenue per paying user (ARPPU) metrics can be volatile around releases and updates, I believe the long-term trend paints a clearer picture of the power of Nexon’s business model.

While MAUs have declined at a 17% CAGR since Nexon’s IPO, paying-MAUs have declined at a slower rate of 10% CAGR. At the same time ARPPU has grown at a 22% CAGR. So, even though overall engagement is declining, Nexon’s core playerbase remains and is declining at a slower pace. Furthermore, these core players are spending significantly more over time (over 5x). Given that Nexon’s main IPs are 15+ years old, this makes sense. A player that started playing Maple Story or Dungeon Fighter Online in their teens is now in their 30s with a bigger wallet. To these players hopping online to play Maple Story or Dungeon Fighter with their friends is just a social activity akin to grabbing a beer with friends after work. This core base of players helps to provide a predictable stream of cash flow that Nexon is able to reinvest in its core IP or use to develop and grow new franchises.

Better late (to mobile) than never. There is a narrative in the market that Nexon missed the transition to mobile (the fastest growing gaming platform) and is a dinosaur focused on making games for PC (the slowest growing). With only 32% of sales coming from mobile in 2Q21, this is not entirely false. However, the company is beginning to make material progress in its transition to mobile with mobile revenues having grown at 24% CAGR from 2018 when it was only 22% of sales.

Nexon does not break out mobile vs. PC revenue by franchise, but 4 of its top 7 IPs have already been transitioned to mobile so far.  Next up is its largest IP with Mobile Dungeon Fighter in China. The game was originally planned to be released in August last year with Tencent as its publishing partner but has faced a long delay with no clear guidance from the company as to why and when the game will finally be released. With the recent regulatory focus on gaming in China, there remains uncertainty around when the game will finally launch. When it does, it seems positioned well as the Dungeon Fighter IP is extremely popular in China and the game already has more than 60mn pre-registrations.

All 60mn of these pre-registrations are unlikely to convert to MAUs, but let’s assume that 50% (30mn) of them do. If we apply Nexon’s current 19% pay rate and ¥7,700 ARRPU to this group it would imply 5.7mn paying users generating ~¥44bn in revenue, an incremental 15% to Nexon’s LTM revenue of ¥290bn.

Reports of PC gaming’s death are greatly exaggerated. While the global mobile gaming market is big ($90.7bn) and growing fast (18% CAGR since 2016), PC continues to be sizeable ($35.9bn) and somewhat growing (2% CAGR over the same period). Nexon is one of the major players in this market with a ~5% market share. And while Nexon’s PC revenues have grown in step with the PC market at a 2% CAGR since 2016, this is misleading. Nexon’s PC results have been a tale of two stories: China and ex-China. In China, Nexon’s PC revenues which are primarily from Dungeon Fighter Online have declined at an 11% CAGR since 2017. I address the reasons for this further below. Ex- China, Nexon’s PC revenues have actually grown at a 20% CAGR over the same period.

Upcoming catalysts. Beyond the Mobile Dungeon Fighter release in China, Nexon has several other upcoming catalysts that could add significant upside to earnings. The most exciting of these is the untitled game from Embark Studios, which Nexon fully acquired in 2019. While not many details have been shared yet, we know the game will be a sci-fi themed third-person shooter that will be F2P and team-based. The team behind it is responsible for EA’s Battlefield franchise, and they have generated buzz in the industry with the short glimpses of the project that have been shared so far. While these things tend to be difficult to predict, the table below shows the playerbase of recent games that could be considered in the same genre. Let’s assume Embark’s new title can reach 15mn MAUs and that 10% of these players will be paying-MAUs (vs. 19% for Nexon overall). At a ¥5,000 ARPPU (vs. ¥7,600 for Nexon overall) the game would generate ¥75bn in revenue for Nexon (25% of LTM total revenue).

Also, in 2H22, Nexon is expected to release the next iteration of its Kart Rider franchise called Kart Rider Drift. This will be the first game in the series (and a first for Nexon in general) to be launched on console along with PC and mobile.

Beyond the upcoming games that I have already mentioned, Nexon lists an additional 14 games in its pipeline: 12 new IPs and 2 which will round out the transition to mobile of its major IPs (Mabonigi, Talesweaver).

Volatility (and opportunity) around updates. Nexon makes seasonal updates to Dungeon Fighter and Maple Story multiple times a year. Sometimes these updates are not received well by the games’ players. When this happens, it is typically reflected in Nexon’s financials through a decline (or at least deceleration) in Nexon’s ARPPU growth trend. As shown in the chart below, Nexon’s share price is particularly volatile during these occurrences. However, it is important to note that Nexon has successfully recovered each time. This is because the company maintains a strong relationship with its players and works with them to understand and rectify these issues when they occur.

This is especially important to understand because Nexon is working through one of these situations in each game currently. For Maple Story, the issue simpler. Rather than content, the problem stems from negative user reactions to the way in which Nexon disclosed virtual item probabilities in its Q1 update. The issue has been addressed, but in response the company has been more cautious with monetization as it regains player trust.

With Dungeon Fighter, the issue is more complicated and dates back to 2019. In short, a major update upset the balance between hardcore, middle, and light users. Attempts to solve the issue have overcorrected each time, favoring one group or the other each time. It finally seems that Nexon is successfully working through this issue with China ARPPU returning to growth in Q2 and management noting that Dungeon Fighter China MAUs and paying-MAUs have returned to growth since July. This also happens to align with Nexon’s decision to reappoint Meyong-Jin Yun to run Dungeon Fighter. During his previous tenure running the franchise (2014 to 2017) revenues more than doubled.

Long-term focused management. I believe that Nexon is in more than capable hands under CEO Owen Mahoney. He’s held the CEO role since 2014 and been with the company since 2010. Before that he was responsible for M&A at EA during a time when the company acquired several studios that are behind some of the publisher’s biggest franchises today. On Nexon’s calls he is constantly reiterating the long-term vs. short-term impacts of strategic decisions and remains focused on the quality of player experiences. Given the long-term nature of Nexon’s games, these are important qualities and the right mindset, though admittedly it can be frustrating as an analyst as it often means unclear timelines around new game releases. This is a great example of what Tom Russo calls the “capacity to suffer” as management often foregoes aggressive monetization strategies in the near-term in order to build goodwill with players that has lasting impacts over the long-term.

Potential to monetize IP beyond games. With the popularity of Nexon’s IP in Asia, and the seemingly unquenchable thirst for content by the streaming providers, there exists the positive optionality that Nexon could eventually extend the reach of its IP beyond gaming. Anyone that has frustratingly followed Nintendo over the years as it failed to do so with its IP will shake their heads, and that’s fair. But Nexon seems to be making solid moves that point in this direction with two key hires. In November last year it nominated Kevin Mayer to its board. Mr. Mayer was previously the Chief Strategy officer at Disney where he led the acquisitions of Pixar, Marvel, and Star Wars and was responsible for the launch of Disney+. Then in July this year Nexon hired Nick van Dyk as its Chief Strategy Officer and President of its new Film & Television division. Mr. Van Dyk worked with Kevin Mayer at Disney until 2014 when he left for a similar role at Activision Blizzard. Maybe these moves amount to nothing, but it is hard to argue the potential for increased exposure that a series or film based on a Nexon IP could bring. Just look at what Netflix’s adaptations of The Witcher and Castlevania did for CD Projekt and Konami in recent years.

Valuation & Financials. The table below compares Nexon’s valuation on consensus estimates to its global gaming peers. Shares are currently trading at a 35-45% discount to the group average depending on your chosen metric, and this gap widens as we look beyond this year. It is fair to note that the discount does shrink when compared to other Japan-listed gaming companies, but this is not as straight forward given Nexon’s Korean roots. Furthermore, the business models of its fellow Japan-listed peers are more of the classic gaming models focused on individual releases which has historically been more boom and bust in nature. The Korean group is a more apt comparison with similar ongoing live-service business models.

As previously mentioned, we have no visibility on the release schedule of Nexon’s upcoming games. However, we can make some very conservative assumptions. The issues described earlier led Nexon’s revenue to decline 13% y/y in Q2, the first quarter to not benefit from a “COVID bump”. If we assume that for the year Nexon’s revenue is similarly down 13% as it works to recover from those issues, it will generate a ~¥252bn revenue base exiting 2021 (Street has them at ¥290bn). At a 40% EBITDA margin that puts the business on 10x EV/EBITDA and 23x P/E (15x ex-cash). Next, we have the upside from Mobile Dungeon Fighter and Embark’s untitled release, which we estimated above to add ~¥119bn in revenue. The company also has Kart Rider Drift and 14 other games in its pipeline. If we assume that only 5 of these are released in the next 18 months and can generate ¥5bn in revenue per game, that would be another ¥25bn in incremental revenue. I believe these to be extremely conservative assumptions. Combined they would put Nexon’s at a ¥ 396bn (¥252+¥75+¥44+¥25) revenue rate exiting 2022 with zero credit for any recovery in Maple Story and Dungeon Fighter. At that revenue base, Nexon likely does 45% EBITDA margins, generating ¥178bn in EBITDA and ¥126bn in net income, which would imply an EV/EBITDA of <6x and a P/E of <13x (8x ex-cash). I believe this is simply too cheap for a business of this quality.

Beyond the attractive valuation, I believe Nexon’s balance sheet also provides significant downside support. The company carries ~¥580bn of cash with no debt and another ~¥120bn in investments in public equities of global entertainment companies. Combined (¥700bn) this accounts for ~45% of Nexon’s market cap.

Catalyst

Upcoming releases of Mobile Dungeon Fighter, Untitled game from Embark, Kart Rider Drift, and the rest of the pipeline

Recovery in core Maple Story and Dungeon Fighter engagement