By Connor Haley
Gravity Corporation (GRVY) is a South Korean company that develops and publishes online games, mobile games and merchandise based on the characters of its games. Its most popular game, Ragnarok Online, is a massively multiplayer online role-playing game (MMoRPG) from which the vast majority of the company's revenue is derived. However, while still a strong source of revenue, this game is now ten years old, and a much delayed and long-awaited replacement finally appears to be on its way, promising to reveal the huge value hidden away in GRVY shares.
To begin, shares of Gravity are cheap. At the current market price of roughly $2.39, the company trades at .7X book value and only slightly above the company's substantial cash position, leaving little room for any implied value for the company's major upcoming catalyst. Its net tangible assets balance leaves a strong floor at $1.99/share. Gravity's price/book and price/net tangible asset ratios are far below the norm for the industry: competitors like Shanda Games (GAME), Activision Blizzard (ATVI), EA Games (EA) and Majesco Entertainment (COOL) all trade at far richer multiples.
The picture gets even rosier when the company's earnings power is factored in. Gravity had EBITDA of roughly $8 million last year, based on merchandise sales, licensing agreements and revenue from its various active games, including the original Ragnarok. To value this stream of earnings, without accounting for any future growth, we use the Earning Power Value (EPV) metric. Dividing the tax adjusted earnings ($6.04 million) by a conservative estimate of the company's WACC (11%) gives us a present valuation of the company's future earning power, in this case $1.98/share. Once the company's significant cash position ($1.26/share) is added in, that gives us a very conservative valuation of the company of $3.24, assuming no profit growth.
However, we believe that "no-growth" is far too pessimistic, because in the coming months the world will be introduced to Ragnarok 2, the eagerly awaited successor to the wildly popular first game. It has been a long and tortuous wait for investors and gamers alike: the company prepared to launch the game in 2005, releasing game footage and promoting the game at the Toyko Game Show, but horrible reviews and weak gameplay meant the title never made it out of its beta launch, prompting the company to begin a ground-up redesign in 2008. Investors were burned horribly by the botched release, with the stock plummeting from $7 to $.60 in a single year as the beta test floundered.
Now, however, the company believes it has things right, and the loyal fan base is still chomping at the bit to try the new game. This was evidenced by the recent success/failure of the first public beta test of the new game, with 200,000 players jamming the servers, though a quickly discovered bug that allowed players to duplicate iterms of the value in the games currency forced a shutdown. Though the difficulties appear to have dampened a rise in the stock in anticipation of the title (shares are off 20% from their recent highs) we believe this is actually good news for the company, because while investors appear to be displaying a good deal of skepticism with regards to the game's prospects, the gaming community most certainly is not.
So, based on our own research on the game itself and the recent beta test, we believe the current share price reflects a gross underestimate of the potential of this game, and that it will lead Gravity to strong, profitable growth in the coming years just as its predecessor did. Though it is always difficult to predict the success of games, we feel that a return to EBITDA levels seen in 2004 is very possible, leaving us with a potential total value per share of roughly $10, roughly where GRVY traded at the peak of the original Ragnarok. More importantly, though, we believe the company is undervalued even without factoring in Ragnarok 2, with an EPV of $3.24, more than 30% above current price levels. In short, Gravity is cheap relative to its current book value and earnings power, with massive potential upside from the upcoming game that could make the stock a true homerun.
Trading at only a slight premium to tangible book value and more than 30% below our no-growth valuation with huge upside potential, we believe Gravity is a buy at these levels.