Gravity: A Classic Mohnish Pabrai – Huge Upside Limited Downside Risk (NASDAQ:GRVY)

Investment Thesis

Gravity Co. (NASDAQ:GRVY), an online and mobile gaming developing company, has surged in sales thanks to the Ragnarok series. With a stable leadership team and strategic market entry, it’s poised for growth in the expanding mobile gaming market.

Gravity’s attractive valuation, low P/E ratio, and strong financial position make it an appealing investment compared to peers. Exclusive rights to Ragnarok until 2033 offer stability, but competition and IP reliance pose risks.

In essence, Gravity’s stock has the potential to double in price when valued alongside peers, with the added possibility of producing another blockbuster game, driving the stock to a P/E of 30. This scenario aligns with Monish Pabrai’s analogy of the stock being akin to a free lottery ticket.

Gravity’s stock has the potential to double in price when valued alongside peers, with the added possibility of producing another blockbuster game, driving the stock to a P/E of 30. In the context of this promising scenario, one can draw parallels to Mohnish Pabrai, a renowned investor and businessman. Pabrai’s insightful analogy likens Gravity’s stock to a “free lottery ticket.” In essence, this comparison captures the idea that, akin to a lottery ticket, the stock presents an asymmetric risk-reward profile. It suggests that the potential for substantial gains far outweighs the associated risks.

The Company

Gravity operates as a developer and publisher in the online and mobile gaming industry. About 77% of its revenues come from mobile games, with the remainder from online computer games. The company’s flagship titles, such as Ragnarok Online, Ragnarok M: Eternal Love, Ragnarok X: Next Generation, and Ragnarok Origins, are part of the Ragnarok intellectual property. The games follow a free-to-play model, with revenue primarily generated through in-game purchases or microtransactions, accounting for about 75% of the company’s sales. The remaining revenue comes from royalty and licensing fees, indicating collaborations with other publishers. This diversified revenue model showcases Gravity’s adaptability within the gaming industry.

The majority of the company’s revenue, specifically 92%, is generated from the Ragnarok series of games.

The customer base for Gravity’s mobile games spans a broad target audience due to the games’ characteristics of short playtimes and simple user-game interactions. While these games primarily fall under the category of MMORPGs (Massive(ly) Multiplayer Online Role-Playing Games), traditionally known for attracting a diverse audience, Gravity’s approach seems to cater more toward a casual audience compared to other MMORPGs. The main motivation for customers engaging with these games is entertainment, emphasizing a more casual and leisure-oriented gaming experience.

Gravity made its entry into the NASDAQ Global Market in 2005 through an American Depositary Share listing. An American depositary share (ADS) is an equity share of a non-U.S. company that is held by a U.S. depositary bank and is available for purchase by U.S. investors. This structure facilitates the trading of shares in the US market, providing American investors with access to Gravity’s equity.

In 2010, Gravity made a significant acquisition by obtaining a 51% stake in Barunson Interactive, the developer of Dragonica, for $10 million. This transaction represented a substantial portion, specifically one-fourth, of Gravity’s total revenue during that period.

In 2015, Gravity entered into a strategic agreement with Shanghai-based Dream Square. The collaboration aimed to develop mobile games based on the Ragnarok intellectual property (IP), further expanding the company’s presence in the mobile gaming sector.

The most substantial costs for the company are categorized under “Fees and Commissions.” Although the specific components of this category are not explicitly detailed, it includes significant expenses such as mobile platform service fees, royalty payments, and outsourcing fees. Notably, mobile platform service fees, which are typically imposed by platforms like App Store and Google Play, often range from 15-30% on app transactions.

Management

The leadership team at Gravity demonstrates a significant commitment to the company. The CEO, Chairman, and CFO have been integral parts of Gravity since 2008. Similarly, Chairman Yoshinori Kitamura has been with the company since 2008, leading the board since 2011. CFO Heung Gon Kim has been an essential part of Gravity since 2008, contributing to the company’s financial leadership and strategy for over a decade. This longstanding commitment from key executives underscores a stable and dedicated leadership team, providing a solid foundation for the company’s ongoing success.

Growth

Gravity experienced explosive growth in both sales and profits from 2016 to 2019, a period marked by the strategic move to introduce the Ragnarok intellectual property to mobile game players.

The catalyst for this remarkable growth was the game Ragnarok M: Eternal Love. Since the success of Ragnarok M: Eternal Love, Gravity has continued to capitalize on the Ragnarok IP, launching two additional games that have gained significant traction: Ragnarok X: Next Generation and Ragnarok Origin. This ongoing success with multiple games within the same IP underscores Gravity’s ability to leverage and expand its key franchises.

According to Statista, projections indicate a 7.43% annual increase in the global mobile games market between 2023 and 2027. This forecast suggests a continued growth trajectory for the mobile gaming industry during this period.

Considering Statista’s forecasted 7.43% annual growth in the global mobile games market between 2023 and 2027, and noting Gravity’s consistent 9% operating income growth from 2020 to the trailing twelve months of 2023, I am adopting a conservative stance in estimating Gravity’s annual revenue growth. Despite the potential for a more aggressive estimate based on the operating income data, I choose to err on the side of caution, anticipating a 5% growth. This decision is guided by the recognition of the inherent unpredictability in the mobile gaming industry, aligning with the adage ‘better safe than sorry’ and acknowledging the uncertainties in market dynamics.

Success in this industry can lead to significant growth, as seen in Gravity’s past, but substantial investment in game development can precede any major success. It’s crucial to consider Gravity’s future if it doesn’t produce another blockbuster game. The company suggests a relatively short life cycle for mobile games, but looking at the prolonged success of their major titles, this assertion might be conservative.

Angry Birds Example

Some games, like Angry Birds, have shown longevity over time. Gravity’s potential for longer success may be impacted by user-switching between similar titles.

To achieve significant growth from new games, Gravity needs to monitor mobile game rankings, particularly on platforms like SensorTower. For instance, Ragnarok M: Eternal Love’s success was evident by its long-lasting top 5 presence on Apple’s and Google’s stores.

Gravity’s cash hoarding may aim to build a financial reserve for developing future titles. Developing in-house titles has explosive growth potential compared to acquiring games through deals, making a substantial cash reserve vital for strategic game development.

Competitors

Gravity operates in an intensely competitive industry marked by swift technological advancements, encompassing both small indie developers and larger companies with more significant financial capabilities. Entry barriers are decreasing, thanks to global online marketplaces like the App Store and Google Play Store, making it easier for even the smallest developers. Game engine companies like Epic Games further streamline game development, increasing industry commoditization. Gravity acknowledges the escalating competition, anticipating a rise in mobile game developers.

Gravity’s dependence on the Ragnarok IP adds an element of risk to the investment case, as success has mainly been tied to this franchise. However, Ragnarok Online’s enduring popularity over more than two decades provides revenue stability, exhibiting a strong “Lindy Effect.” While the IP moat may not match icons like Pokémon or Super Mario, it remains a protective factor, reinforced by exclusive development rights until 2033.

Despite the simplicity of producing mobile games, gaining visibility remains a challenge, favoring larger firms like Gravity. Comparable peers, including G5 Entertainment, Rovio, Ten Square Games, and Joycity, position Gravity near the top concerning operating margins and ROIC, indicating robust financial performance.

Valuation

Gravity’s current attractive valuation, with a P/E of 4.3, coupled with a robust net cash position exceeding 50% of market cap, positions it favorably. While historical peaks exceeded P/E 30 in late 2020, recent years reflect a more moderate P/E 8, suggesting a potential 20% upside. Comparing to peers like G5 Entertainment P/E 9 and Enad P/E 10, Gravity stands out as an appealing investment option.

Gravity’s superior profitability compared to the industry suggests that the low P/E Ratio may be more reflective of market overselling than the company’s actual performance. The strong financial metrics, including robust operating margins and ROIC, position Gravity favorably within its competitive landscape. This comparative analysis underscores the potential for undervaluation in the market, indicating that Gravity’s current market position may not fully align with its financial strength and performance.

Risk

Gravity faces regulatory risks tied to China-Taiwan relations, as a significant portion of revenues (37%) comes from Taiwan, and China has reservations about youth engagement in gaming. Supplier risks arise from heavy reliance on App Store and Google Play for distribution, with mobile games being less profitable due to revenue-sharing agreements. Additionally, 77% of revenues come from games developed by third parties, introducing some supplier dependence. Customer risks stem from a diverse customer base, with in-app purchases forming a small portion of income. Despite potential risks, Gravity’s business shows low cyclicality, and its strong financial position, boasting a net cash equivalent to half its market cap, minimizes financial vulnerabilities.

Conclusion

Gravity’s investment case has a potential for significant returns if they produce another hit game or make strategic moves with their significant cash reserves. On the downside, competition, management’s capital allocation, and dependence on one IP pose risks. In essence, Gravity’s stock has the potential to double in price when compared to peers, and there’s the added possibility of a blockbuster game propelling the stock to a P/E of 30.