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Gravity (GRVY) Cannot Be This Cheap (Ex-Cash PE 2.2x)

Summary

Gravity sales will increase at a +16.4% CAGR from 2018 through 2020 due to the 4 major title launches & its resilient existing mobile sales.

Its annual OPM will likely expand to double digits toward 2020 due to the increased IP royalty income from China and Japan.

Its stock is undervalued as the current rapid price decline is very much of flow driven (some fear) than a fundamental driven.

Long Gravity (Nasdaq: GRVY) – TP $27.07

I recommend a long on Gravity with a target price of $27.07and 60% upside (Target Fwd 2020 PE of 7.1x) from current price levels within one-year investment horizon. Since its net profit will increase by 89.6% to W29.6bn from 2018 to 2020 and its half of current market cap accounts for its cash-holdings, Gravity should be valued at least PE 7.1x on 2020 earnings (Still PEG ratio below 1x).

Gravity is positioned not only to expand its first MMORPG mobile game into S.E Asia and Japan, but also to release another +3 enhanced mobile titles in 2019/2020. Given my projection of a 36.6% CAGR earnings growth from 2018 through 2020, Gravity is an attractive investment at implied Fwd 2020 PE ratio of only 4.5x (ex-cash PE at 2.2x). This compares favorably with comparable competitors’ 2020 PE ratios: Square Enix 15.7x, Glu Mobile 13.0x, Wemade 9.8x, Com2us 9.5x, Webzen 8.2x, Pearlabyss, 8.2x, and Rovio 7.8x.

Exhibit 1) 2018-2020 Avg. EPS Growth vs Fwd PE 2020

Overview

Gravity Co., Ltd. has been a developer, publisher, and distributer for the popular MMORPG IP: Ragnarok online games internationally, including South Korea, Japan, the United States, Canada, Taiwan, the Philippines, Thailand, Brazil, and China over +18 years. The company was founded in 2000 and acquired by Gungho (Public listed Japanese on-line gaming company) in 2005. For several years in the past, Ragnarok online (PC) game has been touted as #1 in Japan, Taiwan, and S.E Asia, and accumulated over +50mn registered accounts around the world. Gravity has entered into the 2nd growth cycle, transforming its global PC IP into the mobile platform.

Exhibit 2) Historical Ragnarok Online (PC) Average Concurrent Users

Investment Thesis: Long

  1. Gravity sales will increase at a +16.4% CAGR from 2018 through 2020 due to the 4 major title launches & its resilient existing mobile sales. It plans to launch (1) Ragnarok first MMOPRG mobile game in S.E Asia/US and Japan (2) Raganrok 2nd MMORPG mobile game by Tencent (3) Ragnarok mobile games by Dream Square and others (See below exhibit 3).

                 Exhibit 3) Gravity Major Titles Pipeline Expectation

1) Gravity expects to release in S.E Asia/US on Oct/Nov 2018 and Japan on the 1st half of 2019. It expects to generate meaningful sales in that (1) S.E Asia’s historical peak online sales was the 3rd biggest and has the most registered accounts (See exhibit 4) (2) It has been #1 online game for several years (3) Other comparable games such as Lineage Revolution (by Netmarble) and Dragon Nest M (by Actoz Soft) had decent results in the past (W0.25~0.40bn/ a day). Hence, we can conservatively expect W0.17bn/ a day revenue from S.E Asia/US.

                        Exhibit 4) Historical figures in 4 Major Countries

2) For Japan, it is reasonable to expect the highest mobile gross sales (vs. other countries) when released in the 1st half of 2019, because (1) Japanese mobile market is ~3x bigger than that of Korea and has the highest ARPU in the world (2) Japanese customers are very loyal to their beloved IP (Ragnarok Online has been serviced in Japan for +16yrs, #1 online game for several years, and generated the highest peak online revenue – see exhibit 4). (3) Comparable example of Lineage Revolution (by Netmarble) has generated ~W1.4bn/ a day in its first quarter. Therefore, we can reasonably expect at least W0.4bn/a day gross sales from Japan (~#12 google rankings).

3) Tencent expects to release the new Ragnarok 2nd MMORPG mobile version in 2019/2020 (China, Taiwan, Korea, S.E Asia/US, and Japan). During its 1st/2nd CBT testing, it has received more positive feedback than the current one due to the (1) improved graphics (2) more appealing in-game features (3) enhanced monetization scheme. Even if we assume its quality is at par with the current one, we can still expect higher sales, because (1) Tencent is the #1 publisher in China (vs. current one with the boutique local publisher) (2) Gravity has learned the lesson from previous global publishing experience. Despite all this, we still conservatively presume its sales will be at par with the current version [MH1] except in China (Conservative estimates: W70.8bn in 2019 and W166.5bn in 2020).

4) Dream Square and others are also preparing on the mobile games which can be released in 2019/2020. The Dream Square one will be a real-time RPG game whose game-play is available in Youtube. Based on the review, we gave a conservative estimate of W0.08bn/a day. For others, no information is available, so our sales assumption on this game is very low at this point (W0.17bn/a day).

5) Existing sales in Taiwan and Korea can be resilient until the next Tencent launch in that (1) its major updates are expected in Nov (every 4~5 months) (2) Its weak monetization model (No pay-to-win) will hold-up its retention relatively better than other peers (For instance, Taiwan rankings have maintained its top #7 level for a year) (3) Bi-weekly updates rebalance its rankings back to the top #10 level every two-weeks (see exhibit 5). Hence, we expect its sales to decelerate average -8~14% a quarter from the 4th quarter to the next Tencent launch.

                        Exhibit 5) Google Historical Gross Rankings

2. Its annual OPM will likely expand to double digits toward 2020 due to the increased IP royalty income from China and Japan. Since Tencent and Gungho will likely be the publishers for China and Japan, respectively, Gravity will recognize its sales as a royalty income from those regions (10% ~ 15% of the total sales expected). Its royalty sales expect to increase to W35.0bn (12% of the total sales) by 2020, which could enhance its OPM to at least ~11.0% level. Also, its OPM can improve further due to the operating leverage impact.

3. Its stock is undervalued as the current rapid price decline is very much of flow driven (some fear) than a fundamental driven.

1) Recently, Dorsey Wright ETF (3rd biggest shareholder, 4% ownership: ~170k shares) has exited from Gravity. Dorsey is a passive beta index which holds 200 stocks with AUM of $56.8bn and it recently rebalanced its portfolio, removing Gravity. Given Gungho holds 59% of its shares, its float is less than 41% of the outstanding shares (~6.9mn) and avg trading volume is less than 45k/a day. Hence, their ~170k shares dump (6% of its float & 16% of total Aug trading volume) had a substantial impact on its price. Many of other passive funds seem to follow the similar path in the last few months.

2) The current price level ($16.92) is close to that of Oct 12th, 2017 when Gravity released its first MMORPG mobile version in Taiwan, meaning its current price does not reflect any of the past Taiwan + Korea results nor any of the future pipeline expectation. It shows how the current price does not reflect any of its fundamental strength.

                                 Exhibit 6) 3yr Historical Stock Chart

3) Because of its unique circumstances: (1) no sell-side broker coverage available (2) listed in Nasdaq, but ~90% sales coming from Asia (3) lack of US institutions’ awareness in Asia mobile game dynamics (4) lack of Korea retails’ knowledge in US stock market mechanism, there is no broader market consensus available and a greater information disparity among investors. Hence, its price has been driven more by animal spirit than its fundamentals. In other words, it has created a great entry point for the huge upside.

Risks

1. Delays in product launch

It is possible to have one quarter delayed which can create some price volatility. Hence, we reflect all these unexpected events in our model by voluntarily delaying one quarter from all the expected launch dates (See exhibit 2). Even with all these assumptions, Gravity still looks very attractive with a huge upside.

2. Worse than expected new games results

It is very difficult to predict outcomes of the new games based on the limited information. However, since we have the current first mobile version results, it is rather easier to predict whether the new releases will do better or worse than the current one in a relative term. To be conservative, we have estimated the next Tencent mobile to be at par with the current one and internally developed one to do a lot worse.

3. Uncertainty in new pipelines

As mentioned on the Q&A #1, it is Dream Square’s best interest to release as many major titles as possible before the contract ends in 2021, and it has generated +4 titles in 3yrs (+1 title per year), so it is reasonable to expect more.

Disclosure: I am/we are long GRVY.