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Gravity – An Irresistible Force?

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by kelpiecapital

Price – $1.18      Market Cap – $33m

Net Cash on B/S – $1.84


Gravity Co is a South Korean video game corporation primarily known for the development of the Multiplayer Online Role-Playing Game (MORPG) Ragnarok Onlinewhich had close to 40 million users at one point according to the company. The Group’s principal activity is to develop, distribute and publish online games and software. It is also involved in mobile game development, animation, and licensing the merchandizing of character-related products based on its online games. Its principal products are Ragnarok Online and R.O.S.E. Online.





Our Margin of Safety

Downside protection from

(1) $1.84 of net cash per share, you can buy a dollar of net cash for $0.64.

(2) A business that is profitable and cash flow positive; $0.08 of earnings last quarter and $0.06 this quarter. Imagine GRVY makes $0.06 for the next 2 quarters and deserves a lowly 10x earnings multiple = $2.60 stock price excluding the cash and assets.

(3) Possibility of a bid by the majority shareholder to buy out the minority holders (although Gung Ho could have done this just about for free at any point over the last 2 years given the cash on the balance sheet.)

(4) High return-on-capital business with favourable long-term growth prospects.

(5) Income and book value has grown year over year since 2005.



Gravity listed on Nasdaq on the back of the hugely successful game Ragnarok Online, one of Asia’s first and most popular MMORPGs. The company raised $71 million at $13.50 per share in 2005 (another example of a terrible IPO to participate in!).

We wouldn’t be discussing Gravity here if everything had gone as laid out in the IPO prospectus in 2005. The highly anticipated release of Ragnarok Online 2, the sequel to the company’s best-selling game, has been delayed repeatedly, causing revenue to decline and development costs to increase. Shareholders have been repeatedly disappointed and the uncertainty regarding the future of Ragnarok 2 has exasperated everyone involved. The deteriorating fundamentals led investors to scrutinize other aspects of Gravity, including the company’s lacking corporate governance under Korean laws and even fraud and embezzlements committed by former management.  U.S. activist hedge funds Ramius Capital and Moon Capital sued the company in South Korean courts and won certain concessions on governance matters.


The Business Model

MMORPG developers receive royalties and fees from users for the use of the game servers, platforms and software. Customers can either pay per hour or per day which is the traditional model or alternatively now users can pay more money for in-game points which allow gamers to advance within the game at a faster pace.

Most MMORPG are “Free to Play” now. What this means is that users must pay money incrementally to advance within the game. Weapons, charms, clothes, food, presents can all be chargeable items and can be priced differently to distinguish between users status or allegiances.  This in the long run should create more revenues as it allows them to extract maximum potential revenue from each gamer. It is possible that someone who was paying for a monthly subscription but is a seriously heavy user is now paying a multiple of their subscription rate. Once a gamer gets hooked they are likely to be very price insensitive for the best “power ups”.


The Size of the Addressable Market

The worldwide online (PC) gaming industry has grown about 10% a year from 2005-present (primarily from growth in Asia). It also doesn’t seem unreasonable that this growth rate can continue for another 5-10 years.

The Ragnarok Website claims 40 million users for the first game. In Asia, multiplayer games are HUGE. I know this from my time living in Singapore, imagine 5 storey arcades filled with boys AND girls all gaming furiously. See below a clip from the Original 9 year old Ragnarok which was posted only 3 years ago which demonstrates the staying power/enduring addictiveness of the Ragnarok brand. 700,000 views too!


Ragnarok grew rapidly in popularity and reached peak subscribers in March 2005. It has been the top online (PC) game in Japan since 2005. Ragnarok is also reported to be the top online game in Taiwan, Thailand, Malaysia and Singapore and is currently offered in 38 countries and 14 languages. As an indication of the excitement (which admittedly must be waning!) around Ragnarok 2, YouTube has 2,800 trailers and clips from the beta games.  Considering that YouTube is more US/Western oriented and Ragnarok is primarily an Asian phenomenon, this seems to indicate good buzz.

Ragnarok One is now available on mobile phones – which should allow an extra few million dollars of revenue per year possibly. Conveniently, this may also broaden the revenue base away from the reliance on traditional avenues.




  1. Requiem – 5% of total revenue and revenues continue to rise.
  2. ROSE Online – 1% of revenues
  3. Emil Chronicle Online – Over 1% of revenues
  4. Estar (tentative title) – In development
  5. Canaan – Recently went through beta testing.
  6. NeoCyon – Various mobile games are released through this subsidiary. Revenues are increasing and multiple news reports have come out of new mobile games. The 2009 revenues were $7 million.
  7. HAVE Online – Entered into publishing agreement with online game developer to publish game in Korea and Japan. Expected release was third quarter 2010.
  8. Dragon Saga – Purchased over  50% from Barunson Interactive. This game was launched in late 2010 with excellent reviews.
  9. War of Gods – Entered into publishing agreement with another company to publish in Korea in late 2010.
  10. Weapons of Gods – Entered into publishing agreement with another company to publish in Korea. Expected release is third quarter of 2011.

Source: http://www.gurufocus.com/news/130916/is-a-5-stock-selling-for-under-2


With regards to this pipeline of games I think it’s best to use a metaphor. These 10 games will not all become a success but with 10 “shots on goal” we have to hope that if our developers have any skills and know their market; as the success of Ragnarok demonstrated they do; then they will hopefully score a hit with at least one of them. I don’t think there is any merit in trying to guesstimate which of these games will become a hit and which won’t. Remember when the Crazy Frog went viral? I would suggest that gaming and online content is a Black Swan rich environment.

This is an industry where the upside is exponential too; if the creators of Farmville can create games worth $9bn, Tencent worth $26bn and Facebook might be worth $80bn then I don’t think it’s an unimaginable possibility that Gravity can create an online game worth $60m or about 2x the current market cap!

If something, anything good happens here, the stock could explode upwards. Nevermind arguing what multiple Mr. Market should pay for Gravity. The company still trades for less than net cash! There is extreme optionality in the stock at current levels in my opinion, an attractive risk/reward payoff.

I view this holding as a “statistical position” a small, free option on a positive non-correlated outcome. If nothing comes of it, I will barely feel it; if something good happens it may have a significant impact.


The Never Ending Beta Testing of Ragnarok 2

Ragnarok Online was introduced in 2001, where players participate with others in a world based on Norse mythology where the fight monsters and achieve great powers.  10 years later after great success, the sequel still hasn’t been released. The long awaited sequel, the imaginatively titled Ragnarok 2, has been in various forms of beta testing since May 2007! This is a lifetime in terms of gaming with huge advances having been made in this time. The average computer game takes less than a year to develop as demonstrated by Madden/FIFA/Modern Warfare/CoD updates released frequently. The first beta versions were poorly received and the company had to go back to the drawing board and redesign it from scratch. With each disappointment the stock has found lower prices!

 “The launch of Ragnarok Online II has been delayed on a number of occasions but we don’t want to launch it before it is ready and want to ensure that it meets the expectations of our players as well as those of our own. We will continue to refine Ragnarok Online II and look forward to providing our users with a high-quality experience.” President and CEO of Gravity.

Clearly, these Koreans are perfectionists but there is a small chance that what they are producing will be worth the wait.

Screenshots from the July 2011 beta testing…


And a recent news item….


I hope upon hope that this will be the final iteration of beta testing for the game and that it will be received positively, but really we just do not know at this stage till the gamer comments hit the blogs and forums from the 16th.

If Ragnarok 2 ever actually gets released, Gravity could go from a balance sheet/deep value story to a growth story, with huge earnings leverage now the company has been stripped of costs.


Other Risks/Problems

1)      It is possible that all the recent fraud issues with US listed Asian businesses have also had a knock on effect in scaring investors away from Gravity. Investors are now hyper sensitive to being caught holding a company that isn’t what it purports to be and the Korean accounts and thin coverage by analysts and Investor Relations may be too much for them. I take some comfort from the fact that PWC are the auditors (although this doesn’t mean THAT much) and that the games are tangible and can be played online – there IS a product.


2)      Nasdaq has a requirement that stocks listed on it have to have a minimum share price of $1. This caused problems during the financial crisis and Gravity had to have meetings with the stock exchange to justify their continued listing.



3)      Management do not own any shares. I find this very frustrating. My own conversations with management have also revealed that they have no plans to do buybacks (despite how powerful they would be at current prices!) but may instead use the cash to fund operations or alternatively make small acquisitions like Barunson.


4)      Capital Allocation is unlikely to be optimal due to lack of insider ownership and Gung Ho’s bargaining power regarding licensing. However, are we being compensated for that when the stock is trading at 2/3 of net cash,  6x a conservative run rate earnings and a free option of a whole bunch of potential home run games?


5)       If Ragnarok 2 flops, which is possible, what then?  How many company management teams will throw the towel in, remit cash to shareholders and call it a day?  More likely management tries to buy something else or keeps investing in the hope of keeping their job a going concern, especially since they don’t own any shares.  The company has improved its cost structure dramatically, but much of the costs are likely fixed at this point.  60% gross margins with some of the COGS fixed implies significant operating leverage on each marginal dollar.  To the upside AND downside.


6)      Will Gung Ho try and take the company private with a lowball tender offer? Even this, which I view as a very bad outcome, would probably still only pass at a premium to today’s prices.



Why is it so cheap?

Gravity is cheap because it has had a few high profile disasters. The majority of its revenue is from one game which is old and in secular decline. Ragnarok 2 has been in construction for years and there is still no release.  Previous management were accused of diverting revenues to personal accounts, and other litigation issues were charged against old management. The new CEO does appear to have put these issues to bed and done a good job of taking costs out, but the history still make investors rightly uncomfortable.


Barunson Interactive Purchase

In late 2010 Gravity purchased a 50.8% equity interest in Barunson Interactive, an online game developer based in Korea. The purchase price was approximately $10.1m. Gravity announced that the purpose of the transaction was to strengthen its online game development capabilities and secure quality online game line up.

Barunson Interactive was founded in 2003 and currently has two massively multiplayer online role playing games (“MMORPG”s) commercially offered, Dragonica and Dragonraja, and one MMORPG under development. Dragonica, a three-dimensional side scrolling MMORPG, is commercially serviced in 10 countries including China, Japan and European countries and boasts 15 million users. Gravity entered into a license agreement for Dragonica in the United States and Canada on August 17, 2010.

Mr. Toshiro Ohno, the President and CEO of Gravity, commented “We expect this transaction will create significant value for Gravity and its shareholders as Barunson Interactive has talented online game developers with great experience. We believe it represents an important step forward to secure continuous profit by diversifying our revenue source and create synergy from the two companies’ online game development teams.”

Barunson has now changed its name to “Gravity Games” and has relocated its offices to the same building as the rest of Gravity Co.


Major Shareholders

Moon Capital (a Korean fund)  and Sprott Asset Management (a resources specialist!?) have both liquidated large positions in the last 12 months. I am a keen follower of Sprott so I don’t like taking the other side of their trades but I would also contend this is well outside their core competence (and likely mine too!). These 2 funds also manage far too much capital for any stake in Gravity to be remotely meaningful to them, I suspect it’s just more hassle than it’s worth to them.

Centaur Capital Partners, headed by Zeke Ashton own almost 2% of shares outstanding, not an insignificant amount relative to his AUM. He is an accomplished investor and owning shares alongside him gives me comfort. I’ve spoken to him briefly about the stock and he views it as a call on something good happening, not unlike my own view.

Gung Ho (a Japanese entity controlled by SoftBank) is the majority shareholder in the company they own over 50% of the shares and they account for 56% of Gravity’s revenues. They are the major controller of the company and this also gives GungHo the options of controlling the board of directors. This is a negative because with a majority shareholder there is little possibility an activist investor can influence management to adopt a more shareholder-friendly capital allocation stance.

Japan is the company’s most important market (about 50% of company sales). Gung Ho is the leading online game publisher in Japan and has the license for Ragnarok (and has the license for RO2). GRVY has disclosed terms of its licensing agreement with Gung Ho for Ragnarok (renewed for three years in September 2009), but the terms of the licensing agreement for RO2 were not made public. With such a major release and with its major shareholder controlling the license in its most important market (Japan), there is risk that GRVY could get the short-end of the stick. It has been suggested in another write up I encountered that GRVY company IR hinted that the licensing terms for RO2 are similar to Ragnarok Online. On the plus side, the 3 year licensing agreement will be up for re-negotiation come Sept 2012.


Update for Today’s Earnings Release

The stock is up 11% this morning because GRVY has reported positive results. Cash and cash equivalents still represent $52.3m against only $18m of total liabilities as of 30th September 2011.

A few highlights below….

“Royalties and license fee revenues for the third quarter of 2011 were KRW 9,535 million (US$ 8,648 thousand), representing a 5.6% increase QoQ from KRW 9,033 million and a 1.9% increase YoY from KRW 9,359 million. The increase QoQ was primarily driven by the weakening of the Korean Won against the Japanese Yen. The increase YoY was mainly attributable to the revenues from Dragonica resulting from our acquisition of Gravity Games Corp., the developer of Dragonica, in October 2010 and the revenues from H.A.V.E. Onlinewhich was commercially launched in March 2011 in Japan. The increase YoY was partially offset by the decreased revenues from Ragnarok Online in Japan.”


“Subscription revenues for the third quarter of 2011 were KRW 2,753 million (US$ 2,497 thousand), representing a 5.8% decrease QoQ from KRW 2,922 million and a 37.4% increase YoY from KRW 2,004 million. The increase YoY primarily resulted from increased revenues from Ragnarok Online in Korea and the U.S. and Canada due to our ceasing subscription-based fee model in Korea in November 2010 and in the U.S. and Canada April 2011 and offering the game with free-to-play servers, which only apply micro-transaction model encouraging our users in these markets to play the game without paying subscription fees or buying playing time and to purchase in-game items. The increase YoY in the revenues from Ragnarok Online in the U.S. and Canada was also attributable to the more frequent updates and introduction of popular in-game items.”

No mention I could see was made of Ragnarok 2 which is still awaiting beta testing next week.



Sources for Further Reading






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