Gravity Ltd.: another look

I first mentioned Gravity, a Korean developer, licensor and publisher of on-line games, last December (2010). At that time I had, over the prior 6 months, accumulated a small position based on a simple thesis: the company had over $1.90 in cash on its balance sheet, was operating on a cash flow positive basis, had no debt and I could buy shares at about $1.58 or 83% of cash. In retrospect my post was a bit flippant. There were some negatives about the company that I didn’t fully analyze. The most important, of course, was the majority ownership by GungHo Entertainment (a Japanese entity controlled by SoftBank). I say ‘negative’ because with a majority shareholder there is little or no possibility that an activist investor can influence management to adopt a more shareholder-friendly capital allocation stance. Furthermore, GungHo is a Japanese company and the most important licensee of Gravity’s primary on-line game, Ragnarok, so there are potential conflicts of interest at every twist and turn.

Let’s start this with a little history. Gravity Ltd. was founded in 2000, launched its first successful game, Ragnarok, in 2002 and went public with an offering of 8 million ADSs in February 2005 at $12 per share. Each ADS was equal to ¼ of a common (Korean) share. Later in 2005 the founding shareholder, Jung Ryool Kim, sold his 51% interest to a Japanese investment fund that in early 2008 resold these shares to GungHo Entertainment. Later in 2008 GungHo purchased additional ADSs which brought their ownership up to 59.3%. As a result, Gravity’s Chairman and COO is Japanese and affiliated with GungHo, and a majority of the Board of Directors are employees of or affiliated with GungHo (There is no requirement in Korea that there be a majority of independent directors). Thus, an investor in GRVY has to accept the considerable potential for self dealing by GungHo. Furthermore, GungHo is the licensee of Ragnarok in Japan and accounts for over 50% of the Gravity’s revenue.

A quick look at the ADS price. From the initial $12 IPO level in 2005 the price trended down steadily to the $6 range by mid 2007. The decline accelerated for the next year and a half, reaching a nadir of $.50 in December 2008. It then rebounded, and between mid 2009 and mid 2011 the ADS price ranged between $1.50 and $2.00. Recently however, the ADSs have begun to decline again, and Friday they closed at $1.16. Why the current weakness? Well, I’m not quite sure, but have come up with 4 possibilities:

1. The price decline is a delayed reaction to the August announcement of the delay in publishing Ragnarok II
2. There was some recent negative news about the company or the industry that I have simply missed
3. This is a random price movement
4. Someone (an individual or fund) is liquidating a significant position

If the reason is #1 above I think it is an over-reaction. After all, the company announced net income of $.06 a share and an increase in the cash balance to $57 million or $2.05 per ADS (more conservatively one should think of this as $51 million and $1.84 per ADS, due to the consolidation of 50%-owned Gravity Games). The delay in releasing Ragnarok II is now in its 4^th year so it really shouldn’t have been so unexpected. If the price decline is due to some unfavorable news I have missed, or, more likely, that certain shareholders are aware of and the rest (like me) are not, there is not much I can do on that score. The third possibility listed above I discount as being rather improbable, though not impossible. So, by elimination I’m left with the fourth; someone selling off a significant position for reasons not related to the underlying business. This would be the most interesting situation for a potential investor and seems to be consistent with recent trading data. Trading volume has increased somewhat lately. Yahoo finance reports average daily trading volume for the GRVY ADSs of 48k over the last 10 trading days vs. a three-month average of 27k.  Furthermore, there have been 5 days since the August market lows with trading volume close to or over 100k shares, a level not seen since last January and February. Perhaps these are indicative, perhaps not, but it is far from proof. For that we would need a schedule 4 or 13, and I have seen none in the past year except a 13D filed by Moon Capital (a Korean fund) which reported less than a 5% holding last Fall.

What level of trading would it take to negatively influence the ADS price? Lets consider the trading volume and the float. Almost all shares in GRVY not held by GungHo are owned in ADS form (the 2010 Annual Report notes that 47% of shares were held in ADS form which of course includes GungHo’s 6.9%).  There are therefore about 11.1 million non-GungHo owned ADSs. The average (three-month) daily volume of 27k is therefore rather light, about 0.2% of the float. Thus liquidating even a small block of shares, say 1 or 2% (275k to 550k ADSs), would have a significant impact on the volume and thus the ADS price. Just for reference a 1% block (275k ADSs) represents about 10 days of trading volume. So it would take a month to trade out a 1% holding if we accounted for 1/3 of all trading in a day. Is that perhaps what we are seeing with the recent price decline?  It’s just a guess. You’ll have to make up your own mind on that.

In any case, the fundamentals of the business seem to be getting better not worse. Income and book value has grown year over year since 2005. Recent quarterly results are less definitive. The $.06 per ADS net income for the second quarter of this year was down from the $.08 of the first quarter, but the run rate is still significantly higher than the full year $0.11 net income of 2010. However, quarterly results have tended to be lumpy in the past, so we can’t necessarily draw any long-term conclusions from the most recent quarterly results. In essence we have an ADS trading at less than 2/3 of cash ($1.80+ in cash per ADS) and a P/E of between 4x and 5x with an option on the successful launch of Ragnarok II. The odds here don’t look too bad. Of course, you have to admit that an optimal resolution is probably not possible in the case of GRVY given the ownership structure; it is unlikely that the company will optimize their capital allocation and buy back shares or pay out a large dividend. Perhaps if there is an extremely successful launch of Ragnarok II management and the board might be incented to reduce their cash hoard, but I wouldn’t bet on it. Even if such a scenario played out it might look more like GungHo trying to take GRVY private with a lowball tender offer. But more likely than not the fate of Gravity is tied to what happens at GungHo or even SoftBank.  Unfortunately, I know little about this, and so can’t speculate.

Still, at current prices, the ADSs seem attractive given the balance sheet and earnings potential. As I said in my post earlier this month, I added to my position in the $1.20-$1.25 range and will look to add more if the price drops 10% or more from here.

As always you should do your own analysis, as mine could be plain wrong.