GRVY

Business Context and Reporting Period

Company: GRAVITY Co., Ltd.
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended December 31, 2004
Business Overview: GRAVITY is a leading developer and distributor of online games, primarily based in the Republic of Korea. The company's principal product is the massively multiplayer online role-playing game (MMORPG) Ragnarok Online, which accounted for approximately 93.9% of total revenues in 2004. The company operates directly in Korea, the United States, and Canada, while relying on overseas licensees to operate and distribute the game in other markets, including Japan, Taiwan, Thailand, and China.

Key Financial Metrics (Year Ended Dec 31, 2004)

Key Margins (2004):

• Gross Profit Margin: 84.0%
• Operating Profit Margin: 59.6%
• Net Profit Margin: 45.3%

Debt and Liquidity:

• Debt: The company had a current portion of long-term debt of W1,278 million (US$1,235 thousand) related to a distribution agreement with Sunny YNK, Inc. There was no long-term debt outstanding as of December 31, 2004. The agreement with Sunny YNK was scheduled to expire in July 2005.
• Liquidity: Net cash provided by operating activities was W32,634 million (US$31,528 thousand). The company held W16,405 million in cash and cash equivalents and W8,900 million in short-term financial instruments.

Material Changes vs. Prior Period (2003)

• Revenue Growth: Total revenues increased by 51.9% to W64,440 million from W42,431 million in 2003. This growth was driven primarily by a 94.0% increase in royalties and license fees (W44,236 million) and a 239.0% increase in character merchandising and animation revenue (W3,471 million).
• Subscription Revenue Decline: Despite overall growth, subscription revenue from Ragnarok Online decreased by 12.4% to W16,253 million. This was primarily due to a 21.4% decline in subscription revenue in Korea, attributed to decreased playing time by users.
• Profitability: Net income nearly doubled, increasing by 99.1% to W29,201 million from W14,669 million in 2003. Operating income increased by 68.0%.
• Operating Expenses: Selling, general, and administrative (SG&A) expenses increased by 23.4%, and Research and Development (R&D) expenses increased by 27.1%, reflecting increased hiring and marketing efforts for new titles like R.O.S.E. Online.
• Foreign Currency: Foreign currency losses increased significantly to W1,052 million (from W240 million in 2003) due to the appreciation of the Korean Won against the U.S. dollar and other foreign currencies.

Guidance, Outlook, Risks, and Unusual Items

Outlook and Strategy:

• The company plans to diversify its product portfolio by launching R.O.S.E. Online (launched Jan 2005) and developing Requiem and Ragnarok Online 2 (expected commercialization in 2006).
• Management expects to continue deriving a substantial majority of revenues from Ragnarok Online through at least 2005.
• The company intends to expand into new overseas markets and increase direct operations in key regions.

Material Risks:

• Product Concentration: Substantially all revenues are derived from a single product, Ragnarok Online. Failure to maintain its popularity or successfully launch new games could materially harm the business.
• Licensor Dependence: The company relies heavily on overseas licensees (e.g., GungHo in Japan, Soft-World in Taiwan) for operations and royalty payments. Deterioration in the financial condition of these licensees poses a significant risk.
• Tax Status: The company benefited from a 50% reduction in corporate income tax (effective rate 14.85%) as a designated venture company. This status is subject to renewal in 2005; failure to renew could result in a substantial increase in the tax rate.
• Internal Controls: The company and its auditors identified material weaknesses in internal controls over financial reporting, specifically regarding the finance team's ability to support U.S. GAAP reporting requirements and reliance on spreadsheet programs.
• Legal Proceedings: As of May 2005, putative class action complaints were filed in the U.S. alleging misrepresentations regarding the decline of Ragnarok Online and other business trends at the time of the IPO.

Unusual Items:

• Equity in Loss of Joint Venture: The company recorded a loss of W248 million from its 30% equity investment in the Animation Production Committee, a Japanese joint venture.
• Impairment Loss (2003): In the prior year, the company recorded a W777 million impairment loss related to an investment in an online game portal business.

Important Facts for Investor Verification

• Renewal of Tax Status: Verify whether the company successfully renewed its "designated venture company" status in 2005 to maintain the preferential 14.85% tax rate.
• Subscription Trends in Korea: Monitor the trend of subscription revenue in Korea, which declined in 2004, to assess the longevity of the core product's domestic market.
• Internal Control Remediation: Review subsequent filings to confirm the remediation of material weaknesses in internal controls identified by auditors.
• Licensee Performance: Assess the financial health and performance of key overseas licensees (Japan, Taiwan, China), as they generate approximately 68.6% of total revenues.
• Legal Proceedings: Track the status of the class action lawsuits filed in May 2005 regarding the IPO prospectus disclosures.
• New Game Launches: Verify the commercial success and user adoption rates of R.O.S.E. Online and the development progress of Requiem and Ragnarok Online 2.