Gravity, or a black hole?
$GRVY makes the rounds of the investment community every few years, usually to disappear from the conversation for a while. Let's go into the business model and capital allocation of this company.
The early 00s had a lot of weird stuff going on. Now that we all have broadband at home, cybercafes don’t seem very practical, but back in the day, it was the best way of playing video games with people. And there are companies still making some money out of them, now as in 2002. Of course, I am talking about Gravity, the maker of Ragnarok Online. MMORPGs seem to be a bit out of style, but RO is a nice throwback to an era of getting together in the cyber after school to grind porings to dust.
Surprisingly enough, while RO's presence has aged as much as its players and it has almost fizzled out of existence in the West, it generates far more money than I would have expected: 86B ₩1 in 2022 (or roughly 69 million USD)… which is much higher than the 42B ₩ generated in 2008, much closer to the heyday of the game, and a lot of it still comes from cybercafés. What wasn't there in 2008 was the mobile gaming area, which in 2022 generated about 4 times as much money as online games.
Gravity’s numbers
While RO still generates some money, the bulk of it comes from mobile. But anyway, let’s stop to talk about RO’s apparent increase in results in the last few years, especially from 2020. A big chunk of the increase comes from Gravity assuming the full operation of RO in Thailand, which essentially doubled revenues. Thailand is the main market for RO, with about as many users as all other countries combined, and Gravity assuming direct control over it boosted both revenue and earnings.
That aside, the business is mostly stale, if not in complete decline. Business in the West and Japan has been declining for some time, but so far it has compensated (at least in terms of revenue) with the absorption of the Thailand and Philippines operations, and growth in Hong Kong, Macau, and Taiwan (where the number of users seems to be growing in the last few years, surprisingly for a 2002 game, although well below 2010 numbers).
So am I expecting this to become a huge revelation and grow more? No, I am quite amazed at how much it is still generating. I do expect the US and Japan areas to wrap up at some point in the near future, especially the US (with only 30% of its 2020 user base still active). Japan’s decline is far slower but still evident. But RO is a declining business, and barring something like absorbing operations in other countries, as happened with Thailand and the Philippines, its weight in Gravity’s earnings will go down.
What is not going down is mobile gaming. In 2022 generated about 4 times as much money as online games, and so far in 2023 it is almost ten times bigger. And sure, part of it is because online games have gone down by around 12%. But mostly it is because the mobile gaming revenue has doubled after the launch of Ragnarok Origin (the sixth mobile game in the universe, if I’m not mistaken) in some countries. Thanks to that, Gravity has already surpassed the record revenue and profit generated in 2022 and is probably on track to surpass 800B ₩ in revenue. Gravity has been able to turn a successful game into a successful franchise.
Gravity is valued at 488M $, or 632B ₩, at the time of writing, with about 400B ₩ in net cash and equivalents. Declining margin or not, paying what amounts to, say, a year and a half of profits plus net cash for a company that has grown revenue every single year since 2015 seems… well, very cheap. So let’s explore the risks they have.
All is Ragnarok
The first and most obvious risk when talking about Gravity is that all revenue comes from a single IP. They have tried to diversify to avoid this risk, but so far they have been utterly unsuccessful, with Ragnarok-related games representing around 96% of revenues in 2022. Efforts include the recently launched Whale in the High and Milkmaid of the Milky Way, and they are so irrelevant I have only mentioned them because the names are funny. And while it is around 96% of revenues, I am pretty sure it is more than 100% of the profits, because I don’t see how that sliver of revenue can support the development of several games. So pretty important to understand how Ragnarok’s IP is being handled.
Ragnarok was, originally, just a manhwa publication made between 1998 and 2001. It sold pretty well locally, so Gravity picked up the rights and developed Ragnarok Online which became a success pretty much worldwide (especially in East Asia). So Gravity was the one to popularise the universe. The original IP belongs to the manhwa creator, Myoung-Jin Lee, though. Gravity got a pretty decent deal with him, getting exclusive rights until 2033, and they even hold the Ragnarok trademark together. In exchange, the author gets royalties: he got only 1.3M USD in 2022, versus 368M USD generated in revenue by Gravity (mostly around Ragnarok products), so something tells me the deal will change a bit in 2033 in his favor. It is not like Gravity is without leverage (Ragnarok’s IP is the games, really), so I think a deal will be reached, as the author would be going against himself otherwise2.
So the situation of the IP is, roughly, that
Gravity depends on a single IP. It has an exclusive license for it for the next 10 years at a pretty favorable rate, and the situation is such that I think a deal will be reached (because other deals have been reached in the past, including cooperation in the development of Ragnarok Online 2 and evolutions of Ragnarok Online, and because Ragnarok’s IP is Gravity's games)
Gravity is aware that is a risk. There were some prior attempts to diversify with IPTV games and an NBA-licensed game (that was only launched in Japan so far), but real attempts seem to have started only recently. 2 non-Ragnarok mobile games were released (Milkmaid and Paladog tactics), and 3 more games in 2023 (Whale in the High, White Chord, only the Japan release of a Chinese indie game, and Wetory). So far, all attempts seem to have failed quite spectacularly (with Whale in the High getting a grand total of 0 references in the Q3 report and presentation, despite being cataloged as a major launch before that), but there are more attempts planned for 2024. It is not a certainty by any means, but at least they are trying.
There seems to have been a successful port of the PC user base of old to the mobile platform, and Ragnarok is still a valuable MMORPG brand (although a different type of RPG than, say, WoW, much more casual-oriented, which they are trying to take advantage of with planed idle games)
Gravity has not developed any of the successful Ragnarok mobile games
Wait… what?
Not a mobile developer in sight
While concerns about the IP-dependence and governance (will get into that later) are common in the few pieces about Gravity that you can find around, there is one concern that I haven’t seen repeated often. And that is interesting since it affects more than 70% of their revenue. Gravity has not developed their (very successful) mobile games. A Chinese company called Dream Square (well, Dream Network Technology Co) did3.
Back in 2015, Gravity signed an agreement with Dream Square. In that agreement, Gravity ceded the rights to publish Ragnarok-based games in China (Taiwan, Hong Kong, and Macao excluded), while Gravity retained the rights over those games everywhere else4. This agreement expired in 2021, and now it only covers support for the existing group games (Origin, X…). The original agreement for game development seems to cover three years of support after launch, which for Origin should be expiring about now, and for X should expire next year, according to the release dates in Korea. MMORPGs are operations-heavy games, and the release strategy Gravity follows, with releases made during long periods (case in point: Origin, which was released in Korea in 2020 and was released in most of SEA a few months ago) lengthens the support period. So… a bit of a risk, although I think the agreements in place will be enough to keep the operations stable5.
How this agreement has been progressing might answer the question “Where are Gravity's new major games since 2021". Well, the agreement all games were coming from expired right then and there was no immediate replacement in sight.
It is worth it to have a look at the economics of this string of decisions. For the last few years commissions and royalties paid to third parties have been the bulk of Gravity's cost of revenue. Gross margin has gone down markedly in the last few quarters, as Ragnarok Origin revenues have taken off (from 48% in Q2 2022 to 33% in the last quarter, more or less in line with the rest of the year). I suspect that part of these is actually caused by the agreements mentioned in footnote 3. As there are relatively short-term agreements to support games with proven economics, I think XD and Huanle had more leverage to get better terms, while Dream Square had a whole long-term deal encompassing many games and probably could not be so aggressive.
The main cause though is the increase in mobile-related revenue in the mix, and actually it is not the first time we saw it. From 2016 to 2019, as mobile revenues grew in importance, margins went through the same process and ended up lower than they are right now (at 26%), and they only went up when Thailand's Ragnarok Online operations were absorbed.
Now, that is not to say those revenues were empty calories. Net profit margin actually increased those years, because in mobile almost everything was externalized… so whatever ended up in Gravity as gross profit was not net profit… but close enough, and operating leverage did its thing, and has been doing it ever since. That 3 of every 4 $ of mobile revenue ended up in third-party providers is just a curiosity and something to take into account when we think about this company and its future.
The future of Ragnarok
In terms of margins, the future might be brighter. In the last few years, Gravity has been investing in developing Ragnarok products internally. And that has culminated in Ragnarok V, and Ragnarok Begins, two new MMORPGs that play both on mobile and on PC, and other projects (an idle title, another casual Ragnarok title and a non-Ragnarok RPG) are waiting.
If those games do well and start cannibalizing the user base M, X and Origins have, we should see a nice increase in margins. It is far from a certainty, though. Ragnarok V's launch in Australia & New Zealand went so well it has already been discontinued. Ragnarok Begins went a bit better in North America. It is still up after a year, and at least 2022 results seemed promising in terms of mobile microtransactions coming from the region -although apps originating them were not disclosed-, and reviews also seemed mostly positive. But I haven't seen signs of very relevant adoption.
Both North America and Australia are small markets for Gravity, and I think what we are seeing are really open betas for the East Asia markets. I would expect both to be refined before launch in the coming months… but not really encouraging. The launch of Ragnarok Begins in Korea in December, and Ragnarok V in early 2024 are things to be watched with attention.
Gravity still has some time. There are some countries pending launch for Origins and X, and that should drive revenue in the short term, especially Origins launch in China, and the potential launch of X there (no authorization yet, as far as I know). I don't think we will see 2024 growth based on that, as the decline in countries were it has already launched offsets the rest, but it should keep revenues at a healthy level. But either they turn V/Begins into a success by late 2024, or they will need something else to keep growing.
GungHo
If there is something anyone who has ever heard about Gravity has heard about is its ever-growing useless pile of cash. I don't have much to add here, really. I consider it as useless as everybody else, and something that could be interpreted as a sign of shenanigans coming from Gravity's majority shareholder, GungHo.
Because of course, Gravity is not an independent company. Back in 2008, their Japanese distributor took a majority stake in the company. And I think that has been good for Gravity overall. You see, back in 2008, what Gravity had was a stable -but long-term declining- MMORPG and not much else. Under GungHo, they developed Ragnarok Online 2, which failed badly… and then turned to mobile. I don't think it is a coincidence that they really started to turn that way after GungHo's success with Puzzles & dragons. And Gravity benefited massively from the turn.
But the rest of their business has been declining of late. GungHo's sales have increased around 15% since 2018, while Gravity's have almost doubled, going from roughly 30% of GungHo's revenues in 2018 to more than 50% in 2022 (and 2023 is even worse). That means Gravity is really GungHo's main unit, even if they don't own it completely.
GungHo does use the company cash to reward shareholders, although in a very prudent fashion. And by that, I mean that they also have an ever-growing pile of cash. Even when you take out the portion that is in Gravity of the cash in their balance sheet, about 25% of their market cap just sits there. So while they are slightly more inclined to reward shareholders of the parent company, it is not like they seem particularly interested in being aggressive. with it.
And that is the biggest doubt one can have about this company really. They have a powerful IP. Some execution risks, but enough time and resources to work out the kinks. A huge pile of cash, and generating still more. But what are the intentions of their owners? Well, who knows?
Personally, I think GungHo will try to integrate them completely sooner rather than later. It is their main business unit after all, and getting so big that it can be problematic if they wait. What form will that take is a different matter, but my bet would be some kind of merger in stock with a not-very-favorable rate to avoid losing Gravity's pile of cash.
Does that make Gravity a bad investment?
GungHo's market cap is about 1.3B $, less than three times Gravity's. They have their own pile of cash (25% of the market cap) and already own almost 60% of Gravity. Their operations, while in decline, are quite profitable. And that would remove the overhang this business has, uncapping it.
Sure, using Gravity's cash for repurchases would be better, but I don't think that is in the cards (I wish). However, I still find myself comfortable with the potential outcomes and the underlying business, so I have a few Gravity shares. I don't think I will ever get really good valuation out of them… but that doesn't mean I won't get good returns!
If you are interested in Gravity and have had a look, please let me know what you think. I also heartily recommend AppInvestor's articles on the company!
These are the total numbers for online games from Gravity. But no one plays Ragnarok Online 2.
Here is the latest amendment of the agreement I could find. And here is the original one. Look, I am not saying it is absolutely terrible. But Shūeisha gets a lot more from Toei Animation (what Toriyama gets is anyone's guess, but hey, Shūeisha is the rights holder here)
Sort of. See the notes below
More or less. There was an initial agreement in 2015 for two games, and then another that extended until 2021 that included exclusivity for China, and then another one for profit sharing outside of China with amendments pretty much every year. Plus, Dream/Fuchum had several agreements with others (Riyu, XD, Shanghai Rexue Network Technology Co…) for publishing and development, which makes everything too overcomplicated to explain in detail.
As for Shanghai Rexue Network Technology Co, please don't confuse it with Shanghai Uzone Network Technology Co, Shanghai Jubao Network Technology Co, or Shanghai Shangyou Network Technology Co… seriously, someone should check what is going on there.
If you remember our old friend Shanghai Rexue Network Technology Co, well, it seems to be better known as Huanle… and it was the original developer of Origins, and is currently supporting it with a direct agreement with Gravity. It is difficult to know exactly how much money goes to them. They were a public company for a bit in the Chinese OTC (NEEQ:836519) but delisted back in 2017.
The same goes for Ragnarok M (but this is XD instead of Huanle), and X was developed by Nuverse, and Gravity and Nuverse seem to have a separate agreement covering service for the next few years.
The publishing of Origins in China, though, seems to be through Ruyi (why that is the case while in theory, XD holds the rights in mainland China for games developed with Dream Square well… your guess is as good as mine. Well, my guess is that language referring to Xindong having exclusive rights in mainland China was incorporated back when Ragnarok M was developed, and never quite corrected to reflect the situation for Origins and X)