Gravity Co. Ltd. (NASDAQ:NASDAQ:GRVY) trades at EV/EBIT 4,0x and 2,4x for 2019E and 2020E, which is significantly below peers (12,8x/10,7x). ROMs recent success in Southeast Asia and North America/South America/Oceania solidifies the global power of the Ragnarok IP. We believe the upcoming launch of ROM in Japan and LaFS in China, with respective local giants Gungho Online Entertainment (JP:3765) and Tencent (HK:0700) as publishers, to accelerate revenue growth in 2019 and 2020. We expect long-term growth to be supported by IP expansion, through entering into new genres, verticals and value accretive partnerships. Gravity currently has no analytic coverage, which could explain the low valuation. As Gravity continues to deliver strong growth in the coming years, we believe more and more investors will grasp the enormous potential of the Ragnarok IP, and that we will see a significant multiple expansion.Before reading this update, we strongly recommend that you read our previous analysis, as it supplements this analysis with information about the company history, the general market, as well showing a breakdown of the income statement.
Highlights for the quarter
Gravity Co. Ltd. recorded Q4 18 revenue of W113.2 billion, representing a yearly growth of 67.7% and quarterly growth of 156.2%. Operating income was W13.7 billion representing a yearly growth of 365.8% and quarterly growth of 93.4%. Net income for was W14.9 billion representing a yearly growth of 204.2% and quarterly growth of 136.6%.
ROM became number one grossing games on Android Operating System (AOS) and iPhone Operating System (iOS) in Thailand, the Philippines, Indonesia and Singapore as well as number one grossing game on AOS in Malaysia.
Highlights after the quarter
ROM made a successful global launch, entering into 42 markets in North America, South America and Oceania on 9th of January, getting more than 1.7 million pre-registrations, 500 000 downloads after three days of operation, and claiming the top 10 of AOS/iOS grossing lists within 9 regions.
Ragnarok M: Love at First Sight (LaFS), with Tencent as a publisher, has received more than 500 000 pre-registrations in China, before game approval and marketing push.
Gravity signed a collaboration agreement with the television series Neon Genesis Evangelion for SEA-region.
Gungho Online Entertainment, the parent company of Gravity, are preparing the service for Japan in 2019.
Southeast Asia (SEA)
The record-breaking quarter was mainly driven by the successful launch of ROM in Southeast Asia on 31st of October. The game has been downloaded more than 7 million times since launch and it has been number one grossing games on iOS and AOS in Thailand, the Philippines, Indonesia and Singapore as well as number one grossing game on AOS in Malaysia. The game generated revenue of around W1.33 billion per day in Q4 according to our estimates.
Two months into 2019, ROM continues to perform strongly in Southeast Asia. Gravity has entered into a collaboration with Neon Genesis Evangelion in order to improve retention through various events and contents. The company has also entered into a joint venture with the Indonesian game publisher Lyto, to strengthen its marketing power in Southeast Asia. (IR Presentation Q4)
We conservatively estimate daily revenue to W0.80 billion and W0.50 billion for Q1 19 and Q2 19, respectively.
Global markets (NA/SA/Oceania)
ROM launched globally into 42 countries in North America, South America and Oceania on 9th of January 2019. The game received more than 1.7 million pre-registrations and the launch was successful with more than 500 000 downloads within three days after launch (IR Presentation Q4). Since launch, the game has averaged third on the Google Play grossing list in Brazil, the 13th largest market in the world. ROM has also performed well in the world’s eight (Canada) and second largest market (United States), averaging 13th and 90th, respectively. The fact that ROM, with its main target audience in Asia, also manages to hold strong positions in large western markets, demonstrates the global power of Ragnarok IP.
As a reference to the global launch one could look at Com2Us (KOSDAQ:A078340) and its game Summoners War, as it is a good example of a Korean IP making a successful expansion into the global markets. Summoners War has been in the top 10 to 100 ranking every year on important North American and European markets since launch in 2015, showing tremendous stickyness in its user base. Q3 18 revenue of ~W120 billion marked the company’s 14th consecutive quarter with revenues above W100 billion. North American and European markets contributed with around 50%, or ~W0.65 billion per day.
It is also interesting to read about Com2Us’ ambitions to expand the Summoners War IP through cartoons, comics and other merchandise. Gaming companies utilizing their IP power by entering into new verticals is a strong trend we see these days. Examples of this is when Rovio (Angry Birds) entered the movie and cartoon vertical, and Epic Games (Fortnite) built its own game distribution platform. IP expansion is still a relatively unexploited monetization area for Gravity and Ragnarok with a great potential.
Another reference in NA/SA/Oceania market would be Garena Free-Fire by Garena Online, which is the gaming division within SEA Limited (NYSE:SE). SEA Limited is a Singaporean digital company with Southeast Asia as its core market. Garena Online has received huge success with its global launch of the survival game, Garena Free-Fire. In Q4 18, the game held the number one ranking on Google Play in Brazil, Argentina, Mexio and Chile. Assuming 90% of its digital entertainment (games) revenue in outside core markets came from Garena Free-Fire we derive at revenue per day in NA/SA/Oceania of ~W0.70 billion in Q4 18.
While Garena Free-Fire only targets a few markets in its global expansion, and holds top positions in those markets, ROM has more diversified revenues, holding steady positions in almost all of its 42 markets. For the aggregated global launch, we conservatively estimate revenue per day of W0.45 and W0.25 billion for Q1 19 and Q2 19, respectively.
Gross Ranking development
The table below shows the launching date, market size and quarterly average gross ranking for Gravity’s main game, ROM on iPhone and Google Play. The ranking development since launch in the different markets give a good indication of the life cycle of the game, as ranking is normally at its highest around launch before it gradually decays. As we can see from the table, some markets show stronger durability than others. Korea has shown quite a low durability, where average ranking on iOS has dropped from 3d to 41st from Q1 18 to Q1 19. This could be explained by lower than average player loyalty among Korean gamers, and the fact that Korea is not seen as a main market for ROM. Although it is a little early to say, key Southeast Asian markets show strong durability thus far, as ROM has been averaging 1st two quarters in a row on iPhone in both Thailand, Indonesia and the Philippines.
Source: AppAnnie, daily gross ranking between 2017-09-30 and 2019-03-01The average duration among every country’s top games is a good indicator of player loyalty in different markets, as it illustrates for how many years the top ten games on average have been operative. The table below highlights that US and Japanese players are more loyal than Korean and Taiwanese players, as the average duration on iPhone is 3.9 and 2.9 years in US and Japan, versus 1.8 and 2.2 years in Korea and Taiwan. The trend is similar on Google Play.
While there is a difference in player loyalty between markets, the largest contributor for player loyalty is the content, IP and marketing of the actual game. Looking at specific games, Candy Crush (Activision Blizzard) and Puzzles and Dragons (Gungho) are some of the games that stand out with extremely long time at the top list in their home markets, with a duration of 5.8 and 6.5 years. From what we have seen from these two games, their success factors have been the continuous expansion of content, IP and brand. We argue strongly that Gravity has similar focus for the Ragnarok IP, which should lead to a very long life-cycle.Source: AppAnnie, Goldman Sachs Global Investment Research
Ragnarok M: Eternal Love in Japan
The most anticipated launch is ROM in Japan with Gravity’s parent company Gungho Online Entertainment as publisher. The game has been prepared for launch since mid-2018, and according to Gravity’s Q4 presentation, the launch is expected to take place in 2019.
The Japanese market is very appealing for ROM, for three main reasons:
The Ragnarok IP is very popular; Ragnarok Online has been serviced by Gungho since 2002, has 4.2 million registered accounts (IR Q4 18 presentation) and is the biggest online Role-Playing Game (RPG) in the country (see picture below). Gungho are very optimistic about the upcoming launch, calling Japan Ragnarok’s main market in their Q4 18 presentation.
Source: Picture taken from GungHo newspaper this year
2. Consumer behavior
Japan is the most mature market for smartphone games, with complex Role-Playing Games being introduced in the late 2000s. Japanese users are picky in terms of localized language, content and marketing. Further, the users are very loyal, so the games need to have rich content for them not to get bored. The demanding consumer behavior is one of the main reasons why foreign gaming companies struggle having success in the Japanese market. In fact, Knives out is the first mobile app from a foreign developer ever to place in a yearly top 10 grossing.
Gravity, with Japanese Gungho as majority owners, are considered a local company in Japan. Ragnarok Online has been serviced successfully for more than 15 years, suggesting that the game and content suits well in the Japanese market. Further, ROM will enjoy publishing power and local knowledge of Gungho, which has great experience in localizing games in Japan.
3. Market size
Japan is the thirds largest gaming market in the world with W19 093 billion in estimated revenue for 2018, behind China (W38 648 billion) and the United States (W36 430 billion), according to NewZoo. For reference, the Southeast Asian market, where ROM grossed around W80 billion in Q4, is estimated at around W4 500 billion. Further, Japan has the highest average revenue per user (ARPU) in the world and revenues from the top ten mobile games account for around 40 % of the mobile gaming market.
The market dynamics described above, makes us very optimistic about the launch of ROM in Japan.
Potential in Japan
To properly gauge the potential of ROM in Japan we argue that peak revenue of original PC MMORPGs is a good proxy for IP strength in terms of addressable user base and Average Revenue Per User (ARPU). According to empirical research by Goldman Sachs (see table below), there is a strong correlation between peak revenue on PC and peak revenue on mobile for MMORPGs. On average, they observe the mobile multiplier as being around 5x. This also holds true when we back-test markets where Gravity has already been launched. In their view, the mobile multiplier is a function of wider reach for mobile platforms and stronger monetization driven by higher engagement, but also more sophisticated monetization schemes.
Source: Company data, Goldman Sachs Global Investment ResearchRagnarok Online’s peak revenue in Japan amounted to W84 billion on a yearly basis (see table below). Applying 5x mobile peak-earnings for ROM in Japan this would translate to W420 billion in revenue the first year of service. We cautiously estimate revenues of W330 billion for the first year.
Goldman Sachs deliberate that in a stabilized state, mobile MMORPGs can still generate +30% (see table below) of their peak annual revenue level. This implicates that sustainable revenue for mobile MMORPGs is 50% higher than the original PC MMORPG’s peak revenue.
The empirical research for MMORPGs switching from PC to mobile, combined with the Japanese market dynamics, suggests huge potential for the upcoming launch of ROM in Japan. It seems that the Japanese market has started to grasp the potential of ROM; 1) According to CLSA Equity Research, the aging of P&D in Japan compels Gungho to find a sufficient offset and the best candidate in the pipeline is ROM. 2) Nikkei News, the world’s largest financial newspaper, recently wrote about Ragnarok being a possible next growth driver for Gungho (see below).
We expect launch to happen in the end of Q2 19, contributing with 15 days in the quarter. We conservatively estimate revenue per day of W1.35 billion in Q2, W1.30 billion in Q3 and W1.00 billion in Q4 19, respectively.
Ragnarok M: Love at First Sight in China
The Chinese mobile gaming market is the world’s largest market, but despite of this, many foreign gaming companies have difficulties to succeed in the market. There are enormous barriers to enter and the market is dominated by the two local players, Tencent and NetEase (NASDAQ: NTES) that accounts for around two thirds of the market. Source: iResearchThe market has had tremendous growth, where mobile revenue has grown by close to 340% from 2014 to 2017. The rapid growth in the gaming market has caused the market to get out of hand. In order to gain better control over the market, the Chinese government imposed a temporary ban on new game releases in March 2018 and implemented stricter regulations on the market as a whole. The three main purposes for the reregulation was to: 1) control that gaming content is not too vulgar or involve politically harming motives, 2) prevent addiction, especially among underage players, and 3) get better control over the larger gaming companies. After a 9 month long freeze, the market opened for new releases in December 2018. The government is currently working through a backlog of around 5 000 games, and on the 8th of March, the eight batch of new games were approved.
The market in China is very fragmented. You have the iOS Appstore that represents around 25% of the market and Android Operating System that accounts for around 75% of the market, with more than 400 accessible Android distribution channels. Chinese law prohibits foreign and foreign-invested gaming companies from publishing and operating video games in China directly. Hence foreign gaming companies needs to enter through a local publisher. The exception for the law, is distribution through Apple’s App Store. Hence, for a foreign gaming company it is extremely difficult to access more than 25% of the market.
In terms of localization, the Chinese market is not much different from the Japanese market. Literal language translation is not enough, successful games need to succeed with translation of culture, legends and history.
In sum, there are big hurdles that needs to be overcome in terms of legal, logistics and localization, to successfully release a game in China, especially if you want to tap into 100% of the market.
ROM has been serviced on iOS through a local publisher, since its launch on 14th of March 2017. The game has received decent success, and in Q1 19 it has averaged 141st and 80th on the respective iPhone and iPad grossing lists. There is a positive trend in the grossing lists the previous months, which could very well be explained by the LaFS announcement (August 2018) and start of pre-registration (January 2019) of the sequel.
LaFS will be launched by Tencent, and thus benefit from the publishing power of the market leading publisher. Although still in Close Beta Testing, the game has already very strong feedback. Compared to its previous version, the reviews highlight that LaFS has 1) better graphics, 2) more interesting in-game features and 3) enhanced monetization scheme. The game has received more than 500 000 pre-registrations before game approval and marketing push. It will go into its third beta test this month. The launch of the game is pending on when it receives approval from the Chinese government.
In Chinajoy 2018, Tencent announced LaFS as one of their 20 game announcements Among them was also another MMORPG, Perfect World, which received its gaming license from the Chinese government in January. This is good news for LaFS and proves three things;1) Similar game has no problem in getting license approved.2) It got a license right after its third Closed Beta Test in January, and launched in March, implicating that LaFS might follow the same pattern and launch shortly.3) It is currently the number one grossing game on iPhone, according to AppAnnie, and grosses around W3.0 billion per day from the iOS alone (iOS platform standing for just 25% of China mobile market). This indicates huge demand for MMORPGs in China.
We cautiously expect the game to release in the beginning of Q4 19, where we conservatively estimate revenue of W1.30 billion per day for the quarter.
2020 and onwards
In 2020, Gravity will be present in all of its major markets. We expect the strong success for ROM to continue into Japan, the market of which we have the highest expectations. We expect LaFS to enter successfully into China, with help of its publisher Tencent. After launching in China, we expect that LaFS will follow the same geographic launching schedule as ROM. The complement of LaFS in the ROMs existing markets, we believe will help the company to keep up a healthy growth pace for years to come.
We expect the healthy growth of Gravity to be supported by further IP expansion. From the pictures below, the company has a very strong pipeline of Ragnarok games in various genres.
Source: Company Q4 18 presentation (note: Ragnarok M: First Love = Ragnarok M: Love at First Sight)Source: play.google.com
Gravity has been developing online games and mobile games on the side of current games and is currently in the progress of developing Ragnarok DS, PSP, XBOX 360 Live PSN to pursue various game platforms. The company is also implementing a wide variety of high-quality global contents and characters related with Gravity games that seeks to expand the current business into publishing, music, merchandising and animation. We also expect the company to enter into new verticals, such as e-Sports, TV-series and movies, to further capitalized on its strong IP and momentum.We anticipate that the ongoing global success will create a virtuous cycle and make Ragnarok even more of a coveted IP. This, in turn, will lead to better options to leverage the IP, for instance by working with stronger developers, and by getting better negotiating terms. For 2020, we conservatively estimate revenue of W796 billion.
Governance and ownership
Gungho Online Entertainment holds 60% of the votes and capital in its subsidiary Gravity Interactive. The main shareholder of Gungho is its founder and chairman Taizo Son, holding approximately 40% of the company, mainly through his holding company Heartis Inc.
Taizo Son is the youngest brother of Softbank’s founder and Japan’s richest person Masayoshi Son. His biggest success so far is GungHo Online Entertainment, which he started in 1998. Taizo Son also serves on the board of ETIC, an institute which provides young people with opportunities to develop their capabilities as social entrepreneurs.
Kitamura is Gravity’s CEO and he serves the board at Gungho, and Gungho’s CEO Kazuki Morishita serves as executive manager in Gravity, linking the companies together.
The management has made strong efforts to highlight the company turnaround with improved Investor Relation, e.g. more transparent reporting through press releases, a newly designed website and list transfer from Nasdaq Capital Market to Nasdaq Global Market in 2018. The company clearly shows initiatives to build a good relationship with stakeholders and taking on the role as a larger company.
According to Gravity’s annual report 2017 the number of shareholders amounted to 2 074.
Financials and valuation
According to our estimates Gravity trades at EV/EBIT 4,0x 2019E vs. average EV/EBIT 12,8x and median EV/EBIT 10,7x for Asian and US peers. Our estimates suppose launch in Japan mid-June 2019 and China in November 2019. All estimates besides Gravity are consensus taken from S&P Capital IQ. The majority having more than 10 analysts covering the company. Gravity lacks analytical coverage at this point.
Revenue expectations have been described above. In terms of gross-margin we have the following assumptions;1. 31,7 % Taiwan and Korea, as historical average Q1-Q3 18.2. 22,3 % SEA, qualified guess when back-testing the Q4 18 figures with help from bullet 1.3. 22,3 % Global, same as SEA4. 18 % Japan and China with Gungho and Tencent as publishers. A few percentage points higher for other markets and releases.Source: Company financials and own estimates. Regarding Q4 18, cost of sales, selling, general and administrative, research and development and other expenses/income aren’t announced before writing this article, so those figures should be considered as estimates.
Risk in delays There is always a risk that games launches could be delayed, and this could cause the timing of revenues to differ severely from our projections. Gravity has guided that the launch of ROM in Japan will occur in 2019. Based on the already long preparation for the launch, and the timing of release of other MMORPGs, we estimate Japan launch in the end of Q2 19. The risk of delay is more towards the investor sentiment than towards the business of the company, as a delay will postpone, but not necessarily alter future revenue.
Regulatory approval for Ragnarok M: Love at First Sight After the ban on new game releases in the beginning of 2018, the Chinese market opened for new releases in December 2018. The government is currently working through a long backlog due to the 9-month freeze. It is uncertainty related to when, LaFS will be released, as it has still not got regulatory approval. There is also the outside chance that the game will be denied. There are no indications that suggest a denial of the release however, and the third beta test coming up shortly suggests that an approval might be around the corner.
Risk of survival games taking share of time from MMORPGsThe recent trend we have seen in the market is survival games, such as Fortnite and Apex Legends, to become global hits over night and gain large market shares. This is also a potential threat for Gravity’s MMORPGs. However, the demographics for survival games and MMORPGs differ, whereas survival games’ main target audience is teens and people in the early twenties, and MMORPG’s target audience is people in the 30’s and 40’s often with long experience of playing MMORPG.
Risk of strong competition from the MMORPG genreThere are several strong releases in the MMORPG genre coming up in 2019, such as Black Desert Mobile from Pearl Abyss, or Perfect World from Tencent, which means that Ragnarok M will face strong competition in the years to come. However, Ragnarok has a strong and long-lasting IP with a loyal audience that has long experience from playing the PC version. Further, the Ragnarok IP appeals more to female players than its competitors. These factors should mitigate competition.AppendixSource: Company data
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Disclosure: I am/we are long GRVY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.