Gravity: Cheap Beyond Rational

Jan. 28, 2022 3:51 PM ETGravity Co., Ltd. (GRVY)36 Comments8 Likes
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Summary

  • Gravity is trading extremely cheap.
  • While a discount can be justified, it seems to me like the current valuation is excessively depressed.
  • I see asymmetric risk/reward in the name with potential for multi-bagger returns.

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Investment Thesis

Gravity Co. (NASDAQ:GRVY) is a gaming company with a single, albeit successful, franchise. The company is trading extremely cheap given its financial success. I believe that the reason for the discount is the company's reluctance in returning cash to shareholders as well as the lack of coverage in the name. While it may take a while, I believe in the eventual use of cash in a value-adding activity catalyzing multi-bagger returns in the name.

Gravity Faces Secular Growth Tailwinds

Gravity is the licensor of the Ragnarok gaming franchise until 2033. The company benefits not just from the growth of gaming which is a secular trend but from the underlying growth dynamics within the industry as well. The company's primarily mobile-driven revenues are exposed to the fastest-growing sub-segment of gaming; mobile gaming is expected to grow almost three times (~2.8x) as fast as the rest of the games. Gravity should benefit.

Furthermore, the company is in an attractive geography in terms of growth. It serves APAC countries with a focus on South Korea and Taiwan. This geography combines population and per capita wealth growth. This should bode secularly well for Gravity. A larger population of which a higher percentage of smartphone ownership will grow the pie for Gravity and the richening of the population will improve monetization. Demographics and economics are secularly bullish for Gravity.

The Company's Recent Financial History is One of Excellence

The growth drivers along with Gravity execution are evident in the company's track record. The company grew from less than $30 mn revenues in 2015 to $357 mn over the past twelve months. The 5-year revenue CAGR for Gravity is ~59%. It can't be said with certainty whether this will continue or not, the gaming world fluctuates very fast and consumer preferences change very rapidly. And it's worth noting that revenues have been slightly decreasing YoY over the past 6 months but the slowdown seems like it's due to tough comps instead of the franchise peaking.

The margin profile is similarly attractive. Gravity boasts 27% EBITDA and 19% Net Income margins. This wasn't always the case, however. Company margins were deeply in the red in 2015 when management decided to outsource production. This, along with extremely fast revenue growth, brought excellent profitability.

It's not just earnings margins either, Gravity is a cash flow machine. The company recorded ~14% free cash flow margins in 2020 and very high cash margins in the four years before as well.

The Stock is Beyond Cheap

I wanted to lay out the fundamental positives of the company before moving to valuation which is the real party piece of this stock. We would normally find a nosebleed valuation in a fast-growing, highly profitable and cash generative asset with a massive cash pile and secular tailwinds behind.

Gravity is the exact opposite and is ridiculously cheap. It's trading at 2.15x LTM EBITDA, 6.56x normalized EPS, and 8.93x FY20 FCF. It's difficult to make sense of the situation. These multiples would only be found in secular losers or companies about to go bankrupt. Gravity is a secular winner with a massive cash pile and cash generation.

I understand the risks associated with a small-cap international stock that is well under the radar. I also understand the fluctuating world of mobile gaming where unicorns are born and die in a matter of months but I cannot pass on the opportunity here, the valuation seems way too cheap. The Ragnarok franchise has been alive and well for a long-time, the investment will pay for itself if it stays for a little while longer.

Two Catalysts Could Bring Outsized Returns in a Short Amount of Time

It's worth looking at the "why" when searching for catalysts in a deep value name like Gravity. I see two main reasons behind why the stock is so cheap. Fortunately, neither of these reasons is structural and could turn around to give easy alpha in the name.

First is the lack of use of the companies gigantic cash pile. As of most recent reporting, the company was sitting on $187 mn of cash and no debt. Needless to say, this is very material given the $413 mn market capitalization of the company. And the cash position isn't new, Gravity's been hoarding incrementally more cash for years. It hasn't chosen to distribute dividends or buy any shares back. It didn't undertake M&A either. This is a big yellow flag as earnings or cash is worthless for investors in any company if they're not eventually distributed.

This may be a policy that is difficult to change with ~60% of the company owned by GungHo Online Entertainment (OTCPK:GUNGF) which in turn is owned by SoftBank (OTCPK:SFTBY) (OTCPK:SFTBF) and Taizo Son, the younger brother of Masayoshi Son. The cash accumulated in Gravity coffers may not be material for GungHo or GungHo may be waiting to deploy the capital in something that would benefit itself which is a key risk.

I'm still bullish on Gravity as the management cannot act in a way that is openly valued destructive for Gravity shareholders. I believe that the cash will be put to good use eventually and generate value.

The second major drawback is the lack of coverage in the name. Currently, zero analysts cover Gravity which is a key risk for institutional owners. Analysts are a stamp of approval and a sign that due diligence has been conducted. It's difficult to bring institutional investors to a name without coverage short of taking the company private (which isn't possible with the majority ownership of GungHo).

I see the lack of coverage as asymmetric upside. The company is priced as undercovered and cannot get more undercovered with zero analysts looking at the stock. If an analyst does initiate coverage though, this would be a very bullish development.

The first catalyst would likely have high convexity as distributions or accretive investments would likely catalyze coverage initiations in the name.

Overall, I'm a buyer of Gravity stock. I can't see the stock faring much worse than where it is without deterioration in company fundamentals and am not particularly worried given the stellar execution over the past 5 years (at least not worried for now). I can, however, see a path to multi-bagger returns in a scenario where analysts pick up the stock or Gravity decides to return capital to shareholders. I'm very bullish on Gravity.

This article was written by

Rogue Trader profile picture
1.57K Followers
Ex HF portfolio manager, Ex management consultant. Now I manage my own money and focus on anything that can create alpha. I will write on any idea I have and lay out my thesis and analysis openly to get feedback from and discuss with the SA community.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in GRVY over the next 72 hours. 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.

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