Gravity - Cheap but an Obvious Value Trap

• Gravity Co., LTD. is a video game developer based in South Korea and trades in the U.S. (GRVY) and is extremely cheap. It’s cash rich and trades at TTM P/E of 8.3. Net income TTM is $35.5m USD vs $295m market cap.

• Net current assets minus all liabilities (NCAVS) is about $198m USD. Market cap is $295m. Backing out the net current assets, the market is valuing the company’s highly profitable business at 2.7x

• Gravity is a real business and has history but is a value trap. The company has no interest in returning cash to shareholders despite the extreme undervaluation. They have explicitly said they don’t plan on buybacks or dividends.

• The company has historically had a large net cash balance and even when it was trading as a net-net (net current assets exceeded the market cap), the company still refused to buy back stock or issue a dividend. Gravity traded below its net current asset value for most of the time between 2008 - 2016.

• Gravity itself has a controlling shareholder (Gungho Online Entertainment), which makes shareholder activism impossible.

• Gravity is EXTREMELY cheap and profitable and worth owning below net current asset value ($28.41) vs $42.33 today.

Oftentimes investing is more about what not to buy than anything else. As a self described value investor it's easy to get caught up in the positives of an investment idea, especially when it ticks most of your investment criteria. Just take a look at Gravity:

Wow! Gravity is cheap and profitable. I’m not going to argue that the business itself isn’t good. While it has some issues, mostly over reliance on a single aging IP, it’s a good business that’s efficiently run. They’re a game developer based in South Korea. I’m not going to describe the business here as there are plenty of write ups online and the company’s own investor presentation decks do a good job highlighting the strengths of the business.

The reason Gravity is a value trap is because the company has no interest in returning cash to shareholders. Not even in extreme situations. Between 2008 - 2016 the company has spent years trading below its net current asset value (net-net). In fact, Gravity has NEVER repurchased shares or paid a dividend since its IPO in 2005. Total return since 2005 are also marginally negative.  If the company wasn’t willing to buy back shares when they trade below net cash, they certainly won’t be buying back shares in the near future. 

This isn’t an assumption either. I’ve reached out to Gravity’s Investor Relations department questioning their capital allocation and they came back to me with the following email:

Not only is Gravity not repurchasing stock, they want to use their cash horde for M&A. M&A isn’t always bad, but there’s simply no asset available to purchase in the gaming space that’s as cheap as Gravity’s own stock. In fact, the last few years has seen an absolute frenzy in M&A in the video game industry. Giants like Tencent, Embracer, and Nexon have been buying up small to mid sized game developers at breakneck speeds. This is bad news for Gravity as any potential acquisition would be competing with serial acquirers with deep pockets willing to pay top dollar for decent assets. Any acquisition Gravity makes is almost certainly going to be destructive to shareholder value.

Another problem for Gravity as a potential investment is that the company has a controlling shareholder. Gungho Online Entertainment, a Japanese listed game developer, owns ~59% of Gravity. This makes shareholder activism, which would already be difficult for a small cap South Korean company, impossible. Gungho has owned their majority stake since 2008 and has licensed Gravity’s games for domestic publishing in Japan. They’re getting access to Gravity’s IPs at arguably preferential terms, so they have no incentive to implement a capital return program.

Gravity is Obviously a Value Trap, But is it Ever a Buy?

Yes. There’s a price for almost any asset and I think despite its issues, Gravity is worth owning when it’s a net-net again (net current assets exceeding market cap). Gravity is currently valued at $42.33 and its net current asset value is $28.41. I’d take a small position if it returns to being a net-net, but would scale in slowly as the company has traded at half its net current asset value in the past. I’d also have to recalculate net current assets if they do end up making an acquisition.

Historically, investors who purchased Gravity when it was a net-net have profited immensely. I owned Gravity in 2011 when it was a net-net and sold for a double in early 2012. I obviosuly regret that now, but the only way I feel comfortable owning a company like Gravity with its littany of issues is when it’s extremely cheap. I missed it when it dipped back below its net current assets, but it's been on my active watchlist since 2017.

Tickers: $GRVY, $3765