Gravity Stock: Cheap Beyond Rational (NASDAQ: GRVY)

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Investment thesis

Gravity Co. (GRVY) is a game company with a single, albeit successful, franchise. The company is trading extremely cheap given its financial success. I believe the reason for the discount is the company’s reluctance to return cash to shareholders as well as the lack of coverage in the name. Although it may take some time, I believe in the eventual use of the money in value-added activity catalyzing multi-bagger returns to the name.

Gravity faces the tailwinds of secular growth

Gravity is the licensor of the Ragnarok game franchise until 2033. The company not only benefits from the game growth which is an age-old trend, but also from the underlying growth momentum within the industry. The company’s revenues mainly generated by mobile are exposed to the fastest growing sub-segment game; the mobile game is expected to grow almost three times (~2.8x) faster than the rest of the games. Gravity should take advantage of this.

In addition, the company is located in an attractive geographical area in terms of growth. It serves APAC countries with a focus on South Korea and Taiwan. This geography combines population and wealth per capita growth. This should bode well for Gravity. A larger population with a higher percentage of smartphone ownership will make the pie bigger for Gravity and population enrichment will improve monetization. Demographics and the economy are secularly bullish for Gravity.

The recent financial history of the company is one of excellence

Gravity’s growth drivers as well as execution are evident in the company’s track record. The company has grown from less than $30 million in revenue in 2015 to $357 million in the last twelve months. The 5-year revenue CAGR for Gravity is approximately 59%. Whether this will continue or not cannot be said for sure, the gaming world fluctuates very fast and consumer preferences change very quickly. And it’s worth noting that revenue was down slightly year-over-year for the past 6 months, but the slowdown appears to be due to tough comps instead of the franchise’s peak.

The margin profile is equally attractive. Gravity has 27% EBITDA and 19% net profit margins. This was not always the case, however. The company’s margins were deep in the red in 2015 when management decided to outsource production. This, combined with extremely rapid revenue growth, has brought excellent profitability.

It’s not just about profit margins, Gravity is a cash flow machine. The company recorded free cash flow margins of approximately 14% in 2020 and very high cash margins in the previous four years as well.

The stock is more than cheap

I wanted to lay out the fundamental positive aspects of the business before moving on to the valuation which is the real party element of this title. We would normally find a nosebleed valuation in a fast-growing, highly profitable, cash-generating asset with a huge cash pile and centuries-old tailwinds behind it.

Gravity is the exact opposite and is ridiculously cheap. It trades at 2.15x LTM EBITDA, 6.56x normalized EPS and 8.93x FY20 FCF. It is difficult to make sense of the situation. These multiples would only be found in secular losers or companies on the verge of bankruptcy. Gravity is a secular winner with a huge cash stack and cash generation.

I understand the risks associated with an international small cap stock that is well under the radar. I also understand the fluctuating world of mobile gaming where unicorns are born and die within months, but I can’t pass up the opportunity here, the valuation seems way too cheap. The Ragnarok franchise has been alive and well for a long time, the investment will pay off if it sticks around a bit longer.

Two catalysts could bring disproportionate yields in a short time

It’s worth looking at the “why” when looking for catalysts in a deep value name like Gravity. I see two main reasons why the stock is so cheap. Luckily, none of these reasons are structural and could backfire to give an easy alpha to the name.

The first is the lack of use of the company’s gigantic cash pile. According to the latest reports, the company had $187 billion in cash and no debt. Needless to say, this is very significant considering the company’s $413 million market capitalization. And the cash situation is not new, Gravity has been accumulating more and more money for years. It did not choose to distribute dividends or buy back shares. It also did not carry out any mergers and acquisitions. This is a big yellow flag, as profits or cash are worthless to investors in any company if they are not ultimately distributed.

This can be a difficult policy to change with ~60% of the company owned by GungHo Online Entertainment (OTC:GUNGF) which in turn is owned by SoftBank (OTCPK:SFTBY) (OTCPK:SFTBF) and Taizo Son, the younger brother by Masayoshi Son. The cash accumulated in Gravity’s vaults may not be important to GungHo or GungHo may be waiting to deploy the capital into something that would benefit them, which is a key risk.

I am still bullish on Gravity because management cannot act in a way that is overtly destructive to Gravity shareholders. I believe the money will eventually be put to good use and generate value.

The second major drawback is the lack of coverage in the name. Currently, no analyst is covering gravity, which is a key risk for institutional owners. Analysts are a seal of approval and a sign that due diligence has been done. It’s hard to get institutional investors into a name without coverage unless you take the company private (which isn’t possible with GungHo’s majority stake).

I see the lack of coverage as an asymmetric advantage. The company is listed as underhedged and cannot be further underhedged without any analyst reviewing the stock. If an analyst initiates a hedge, that would be a very bullish development.

The first catalyst would likely have high convexity, as distributions or accretive investments would likely catalyze hedging initiations in the name.

Overall, I’m a Gravity stock buyer. I don’t see the stock doing much worse than where it is without deteriorating company fundamentals and I’m not particularly concerned given the excellent execution over the last 5 years (at least not worried yet). I can, however, see a path to multi-bagger returns in a scenario where analysts scoop up the stock or Gravity decides to return capital to shareholders. I’m very bullish on Gravity.