The Expectations Built into GRVY is Dead Wrong

November 28, 2011 | Comments (15)

All three asset valuations are higher than market value, thus the market is expecting GRVY be a destroyer of value. Looking at the financial statements and following the company for a couple of years now shows that to be completely false. This visual representation shows what each valuation is made up of based on the market price.


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Jae Jun

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Here is an update on Gravity Co (GRVY), a company that I have held for a couple of years in anticipation of their sequel to their original blockbuster mass multiplayer game Ragnarok Online.

Read the initial post with details of the company and what it does, as well as why the company is one of the best deals under $2.

Here is another blogger’s very detailed summary of GRVY.

2011 Q3 Revenue Summary

  • 1.4% increase in revenue compared to comparable quarter last year
  • Royalty and license fee revenue for 3rd quarter increase 5.6% QoQ due to currency gain against the Yen but still a 1.9% increase YoY due to acquisition of Dragonica which was purchased in Oct 2010.
  • Subscription revenue decreased 5.8% QoQ but increased 37.4% YoY. Decrease was due to the French subsidiary no longer being consolidated as GRVY’s ownership was reduced to 25%.
  • Increase in revenue was due to Korea, US and Canada based on ceasing the subscription based fee model and making it free to play. Also attributed to more updates and more items available in the game.
  • 9% YoY increase in mobile games. GRVY launched a few games for the iPhone which were accepted very well. A potential growth platform in the mobile gaming industry, although the competition is fierce.

The most pleasing point is the fourth one where the new business model of offering the game for free has actually increased revenue. Rather than earning revenue by a few big spenders, this model is now bringing in smaller revenue from a much larger user base. At the same time, existing gamers are the ones that will play the sequel when released, so it is also a smart marketing move.

Expenses Summary

  • Cost has increased by 43% due to acquisitions and the increase in payroll. I’m expecting this to increase as GRVY continues to purchase other gaming titles.
  • R&D spending dropped from Korean Won of 955m to W555m YoY
  • Lower tax expenses from W1,207m to W475m

I’ll need more details on what these reduced expenses are about. My guess is that the acquisitions are favorable for taxes. The increased payroll may also include the R&D figures for the acquired companies such that R&D for GRVY itself can be lowered.

Not enough information to be certain though. The annual report will provide the full details when it comes out next quarter.

Valuation Summary

The stock valuation tools can’t analyze ADR’s well due to currency conversion. You’ll have to enter the values manually into the yellow column to display what you see in the image below.

Below is the asset valuation of GRVY in millions of US$.

Net Net Working Capital (NNWC) for GRVY is $1.50 per share. This is a 10% discount to current market price. Remember that NNWC is the most pessimistic of ALL valuation.

Net Current Asset Value (NCAV) is $1.78 per share. This is a 24% to current market price. NCAV is still much lower than tangible book value.

Tangible book value per share is $1.99.

Stock prices reflect the company’s book value and growth expectations.

Market price = book value + growth expectation

In GRVY’s case, all three asset valuations are higher than market value, thus the market is expecting GRVY be a destroyer of value. Looking at the financial statements and following the company for a couple of years now shows that to be completely false. This visual representation shows what each valuation is made up of based on the market price.

As you can see, the market expects GRVY to create negative returns on capital and assets.

Recent Communication by CEO

A couple of other GRVY investors contacted GRVY to discuss the direction of the company and passed along the comments to me. To sum it up briefly, GRVY is not looking to buy back shares as they believe that it is only a temporary remedy to the lagging stock price. They seek to increase long term shareholder value by diversifying revenue sources and reinvest in the business by developing new games and purchasing publishing rights to other small sized game development companies.

What do you think?

More sources: http://www.oldschoolvalue.com/blog/forum/g-stocks/grvy-gravity-co-ltd/

Disclosure

Long GRVY at time of writing

  • Leon

    I’m also bullish on this stock, but there is one piece of negative news that you haven’t mentioned. The original creator the game, Kim Hak Kyu, is working on another game, Project R1, which many gamers think will be the true successor to Ragnarok Online. Many gamers are not satisfied with Ragnarok Online 2, and don’t think it’s different from the many other MMORPGs out there. Project R1, on the other hand, is a mix of 2D-3D and seems to get much more positive reactions from the existing fanbase. There is a danger that if Project R1 is successful, it could significantly cannibalize Ragnarok Online, turning Gravity into a well capitalized gaming company that slowly (or potentially even quickly) burns through its cash hoard.

    I’m a shareholder in Gravity, and I think there’s a lot of upside to these shares, but potential investors should track this risk.

  • Leon

    Hi Jae,

    I came across this stock a while ago, and only recently saw your analysis. I enjoyed reading your analysis and I’m also bullish on this stock, but there is one piece of negative news that you haven’t mentioned. The original creator of the game, Kim Hak Kyu, is working on another game, Project R1, which many gamers think will be the true successor to Ragnarok Online. Many gamers are not satisfied with Ragnarok Online 2, and don’t think it’s different from the many other 3D MMORPGs out there. Project R1, on the other hand, is a mix of 2D-3D and seems to get much more positive reactions from the existing fanbase. One looming risk is that if Project R1 is successful, it could significantly cannibalize Ragnarok Online, turning Gravity into a well capitalized gaming company that slowly (or potentially even quickly) burns through its cash hoard.

    I’m a shareholder in Gravity, and I think there’s a lot of upside to these shares, but potential investors should be aware of this risk.

  • Ankit Gupta

    The comment about not buying back stock because it’s a temporary drop really worries me.

    First, none of the management or board of directors has ownership in the company, see item 6.E.: http://www.sec.gov/Archives/edgar/data/1313310/000095012311062658/h05180e20vf.htm#H05180128

    Second, no stock buybacks worry me because it really questions their ability to allocate capital. If you have a project that will return 10%/year to you, but you can buy back stock that at present prices would imply 20% annual costs, then you provide more benefit to the shareholder by repurchasing stock. Their decision to invest in a new project or buy back stock should be related to the price at which it trades.

    A stock buyback is really one of the many “threats” that I believe helps to keep prices trading in a range within intrinsic value. If the price falls too low, the threat of a buyout arises, because a knowledgeable business person will realize it’s more attractive to own now. Another “threat” to the lack of realization of value is dividends – if it’s a $1 stock, but you see $1.10 coming soon, that will help it adjust. Finally, stock buybacks are another threat as well – if you own a $4 stock and the company buys it back until it approaches an intrinsic value of $8, then that will raise the price. You can have the company bought out, you can issue dividends, and you can buy back stock. I think there are probably other forms of an exit opportunity, but they’re probably derivatives of these (like issuing an asset distribution).

    The biggest question in my mind… why hasn’t GungHo offered to buy them out yet? They already have 60% of the stock – why not make a tender offer for the other 40% and take it over? The cash and short term securities alone will finance it.

    Is there something stopping them from taking over the company that might also limit our ability to realize value, which might be why the stock price isn’t moving up significantly?

  • http://www.oldschoolvalue.com Jae Jun

    I see it as going both ways. So far, the purchases they have made and the decisions related to operations are flat to slightly positive. Better than negative. It remains to be seen whether their capital allocation is better than say a 10% share buyback plan.

    Cant answer your questions because I would be guessing wildly but valid point. Why isn’t Gungho buying the entire company?
    Maybe they don’t have the required financing, board approvals, or the issue with completely buying a company based in Korea?

  • David

    Leon,

    Where do you get the information that many gamers are not satisfied about the sequel Ragnarok online 2. On the MMO site the test version 16-22 nov get’s a 8.3.

    I think many gamers are waiting for the sequal. CEO is shareholder minded because he’s talking about diversifying revenue.

    Jae what do you think about the expectating of gamers regarding Ragnarok online 2?

    Kind regards,
    David

  • Jason

    @Gupta

    The decision not to buy back shares is a good decesion. First, most of revenues come from one game and they should diversfy their products. Second they are a PFIC in the U.S. and buying back shares would make this worse. You should look up the PFIC rules on irs.gov. Actually everyone should cause we all need to make an election on our 2011 tax returns or get taxed at really high rates.

    Don’t get me wrong i was the one who emailed them hoping for a stock buyback. But i was wrong.

    Regarding management not owning shares. Management comes from gung-ho who owns over 50%. So you are mistaken that management is not invested in GRVY.

    Thanks
    jsarasin

  • Ankit Gupta

    Jason – why do we want a company to diversify their product lines? What benefit does it provide for shareholders?

    Think about it this way. What is the difference to me between buying 1 company that owns 10 others versus me just buying stock in those 10 companies? In fact, if those 10 companies are all separate, I can pick and choose what risks I like and the ones I don’t understand enough to own. If I buy stock in a company that owns 10 within it, what choice do I have? I’m sure you could find some way to hedge your risk by taking a short position in a publicly traded comparable, a basket of comparables, or even puts on something, but I’d prefer to not have to do that.

    What is the implication of being a PFIC in its relation to a stock buyback?

  • jason

    PFIC in relation to a stock buy back is based on the percentage of cash to assets at fair market value not its assets on the balance sheet. So the stock price determines the asset base. A one time share buyback will not increase share price to a much higher level when in reality the major issue with GRVY is its lone revenue source.

    Not sure I am getting what you are saying in regards to diversifying its products. To me its simple as turning the cash into future cash flows on top of RO1 and soon to be RO2. A stock buy back would help but not as much as future cash flows in my opinion. I would say you are correct if you are a short-term investor. My investment is long-term right now.

    If your worried of its management making bad decisions with its cash then I would say sell or don’t buy shares. I am confident with this NEW management but also am worried like you with Gung-Ho intentions. But if they planned to buy the whole company they would not be making the positive decisions they are doing. Or at least wouldnt be as explicit that the company is turning around. I did think someone was manipulating the stock price when it was around $1.20 though.

  • http://www.oldschoolvalue.com Jae Jun

    @ David,
    So far the anticipation is mixed because many of these people have been waiting for ages and they’ve grown tired. We have an investment interest so our patience is much longer than these gamers.

    Korean bloggers are saying that there are still bugs that need to be fixed, but overall, the game is a pleasant experience. Not earth shattering, but good enough. Don’t take my word for it though. I’ll have to play it to decide.

    With GRVY (or all your investments) is whether you are on the smart side of the trade. Do you have an edge?

    As a small cap ADR, it’s a good start. It is completely out of favor, so another point there. For me, my Korean is a huge advantage. I can get news first before the market. So despite the whole buyback discussion, I believe I am on the smart side of the trade here.

  • ankitgu

    I’ve continued some comments on the forum: http://www.oldschoolvalue.com/blog/forum/osv-value-stock-picks/

  • J. Harland Brace.

    I was drawn to this stock in the last few months while doing research on the social gaming sector.
    It is clear to me that Gung-Ho is about to make a buy out offer for the company.
    I say this with complete confidence and have backed it up with a substantial purchase of stock in the last few months.
    The tender offer will be at a substantial premium to todays share price and should be forthcoming at any time now and, certainly, prior to the launch of the new Ragonok.
    I now own the position I wanted to accumulate and at a surprisingly low price.
    GRVY will clearly be trading higher in coming sessions.

  • http://www.oldschoolvalue.com Jae Jun

    Hi J Harland Brace,
    Do you have information of the buyout? Although I’m very long GRVY, I don’t believe that will happen anytime soon.

  • J. Harland Brace.

    Gravity Investor Relations manager confirms commercial launch of RO2 in Febuary.

    Below is email from Dec. 19, 2011.

    Dear XXXX

    Thank you very much for your inquiry. I am Yoon Joo Lee, IR Manager of Gravity Co., Ltd.

    Please kindly find the testing and launch schedule for RO2 in Korea below.

    - Final closed beta testing: December 26, 2011 – December 30, 2011
    - Open beta testing: February 2012
    - Commercial launch: February 2012

    Should you have any further questions, please feel free to contact me.
    Thank you very much.

    Kind regards,

    Yoon Joo Lee (Ms.)
    IR Manager
    Gravity Co., Ltd.
    TEL: 82-2-2132-7800
    FAX: 82-2-2132-7070

  • http://www.oldschoolvalue.com Jae Jun

    Ahh yes, they mentioned that they would be releasing more details on Dec 19.
    Thanks for the info.
    Just hope they don’t delay it again. With GRVY, they could easily delay the schedule again.

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