Thursday, March 22, 2007

WZEN: Another undervalued Asian Name?

For whatever reason, the majority of the value I've been finding recently is amidst several Asian companies with businesses in transition, that are trading near cash value. Though I am hesitant on the prospects of China to keep up its tepid growth, value is value, and cash is cash.

WZEN is a South Korean based game developer that is in the process of building a series of high profile releases from proceeds received in IPO about 2.5 years ago. They are currently trading near book value, with limited value being assigned to their attractive game porfolio going forward. Though I am excited about the prospects of the company, I can see this trading down even further, more near something approaching cash value, and would be looking to add the name on weakness before several of their big releases later this year.

Business Overview

WZEN is one of the leading game development company's in south Korea. About three years ago, they released "MU online", which was one of the more popular games in major Asian markets for a couple years. This game propelled the stock, and gave WZEN the clout to become a national game developer. After IPOing, WZEN ramped up development on several big budget titles, including SUN, Huxley, Kingdom of Warriors, and APB. WZEN began developing many of these games 2+ years ago, when they received their big cash infusion, and are getting ready to release many of these games within the next year or two. As WZEN has ramped up developement, they have accrued significant costs without any revenue benefit (they do not receive revenue until the games launch). At the same time, they have experienced a decline in MU revenue, due to the natural aging of the franchise. This combination of investing in the future, and eventual winding down of MU revenue has led to an apparently grim operating picture, though things aren't nearly as bad as them seem. Typically, developers expense upcoming games while they are receiving current income from the games they have developed in the past. Becasuse WZEN has been ramping up its developement so rapidly, and because they have not released a game for quite some time, the financial picture is currently distorted. As new games are released over the next year or two, we will begin to see the investments of the past two years ($50M+) reap dividends.

The Games
WZEN has several games in varying stages of development. I will outline a few of the big launches below, including timing, and thoughts on potential

Huxley -- End of 2007
Huxley is a Massively multi-player online game being developed for the PC and Xbox 360. Of all releases to be released in the near future. Though I do not have specific expectations for the release, nor the knowledge at this point to predict sales, I can give some anecdotal evidence I believe to be compelling:

WZEN announced in February that it had sold the rights for China publishing to NCTY, one of the leading Chinese publishers, for an estimated $35M over 3 years (actual can be more or less, depending on milestones) plus a 22% royalty. From what I can tell of operating expenditures over the last 3 years, it would appear as though this one up front payment in China has paid for most, if not all of Huxley's development costs.

In the US, Huxley has received very favorable coverage from Gamespot, the largest online videogaming news/review site. The Xbox 360 version is ranked #5 out of 415 games in popularity, very impressive for a game not launching for at least 6 months. It has also won awards and received very favorable coverage at E3, the largest yearly videogame conference. Though I have not conducted scientific studies on this, gamer anticipation is usually an excellent sign of things to come. Assuming the quality is there (which, by early indications, it is), this seems to be lining up to be a hit.

SUN -- 2007 in various geographies
NCTY also agreed to purchase Chinese rights here, this time for $13M in payments + 22%. NCTY profiled this acquisition as a milestone on its Q4 2005 conference call, and said they had high expectations. Also, accoring to, a popular chinese gaming site, SUN was in the top 2 most aniticpated online games in the several months between August and November. Sun was released in Korea in November, though I have had trouble assessing its success. One thing to note is that, at least in Korea, the game will be free, and be supported through "micropayments", or the in-game purchase of game items (e.g. special swords, charaters, etc.). Because of this payment model, I would expect that revenue will ramp up more slowly, but have more longevity. By providing free access to the game, WZEN creates a hook that gets people to play, and will hopefully eventually induce them to spending as much (or more) as they would have paid under a subscription model.

Though the game appears to have presence in China, prospects in the US seem more dull (it has gotten very little coverage and does not seem to have much anticipation, again using gamespot rating as a proxy.

APB: 2008 Release
Still a year off, but this game is one to watch. It is by the creator of Grand theft auto, which may very well be the most successful gaming franchise of all time. More details to come on this as it is still early in development, but this appears promising

TBD Red 5 game:
Last year, WZEN brought further clout by teaming up with Red 5 to publish their first game. Red 5 was founded by a team of World of War craft developers who have been involved some of the more popular games of the last several years, including Diablo 2, Warcraft 3, and starcraft. They have some very ambitious goals, and though their project has not been announced, WZEN will be set to launch it worldwide when it is ready. WZEN is clearly intent on becoming a force in the development of multiplayer online games.

Other games:
WZEN has 2-3 other games in developement. Though these are not on the same scope as the prior games, they do provide revenue potential as they move from development to launch.

WZEN's ADS shares are equivalent to 3/10 of one share on the KOSDAQ. WZEN's market cap is a bit difficult to track down, but from what I can tell the ~13M shares outstanding translates into about a $180M market cap @4.15. If you back out the ~$100M in cash, the company is trading for an EV (market cap - cash + debt) of ~$90M. WZEN is also burning through about $20M in cash/year, and I won't expect this to change until we see the release of Huxley later this year, so I'll assume they burn through another $20M before breaking evening, giving them an EV of ~$110M. On a Price:book value basis, this is trading at about 1.25x book.

My big concern with the business is that costs have really ballooned here, well beyond what seems to be required for the business. Gross margins on MU revenue fell from about 90% three years ago to under 30% in 2005. I'd assume that this is partially related to the aging of the game, and that a number closer to 80% is what is expected on multiple games (though I need to confirm this). Additionally, SG&A has gone up about $10M. Add onto this $20M is R&D costs (which I expect the company will continue to need going forward, to produce continued hits), and the business is operating on a fixed cost basis of about $45M, much more than the $20M it operated on when it released MU and achieved $36M in profit several years ago. That same revenue, on today's cost basis, would generate $6M in operating profit. At an 80%, instead of 90% margin, the company would have lost a couple million.

In other words, WZEN will need hits about twice the size of MU (~$100M in annual revenue @ 80% gross margin) to return to net income of $35M. This is where the analysis gets tricky, because the video game business has a relatively unpredictable hit cycle. Nevertheless, I'll take a very rough look at how this may play out.

Between SUN and Huxley, I think there's a good chance we can expect MU style revenue, given the existing contracts in place with NCTY, and the degree to which these have been tracking high on the hype meter.

The real wildcard then, in my mind, is the success of Huxley in the US. If present coverage is any indication, this is lining up to be a hit. Even if it is a hit however, it will need o generate $50M+ in revenue to really create the kind of net income impact that would allow WZEN to move substantially from here, given the increased cost base.

For the time being, I will sit on the sidelines here, though I'll be watching to see if this drops nearer to its book value (about $3/share). As the company will continue bleeding money for the next couple quarters, and with the slow revenue ramp of SUN and coninued cooling in Asian names, I think there is a decent possibility. At that price, however, I think the risk/reward becomes favorable enough to make a go at this one. Since I don't forsee any upward catalysts for ~6 months (as we near the release of huxley, and as SUN revenue ramps up), I think this will become a more attractive play

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