GRVY

Business Context and Reporting Period

Company: GRAVITY Co., Ltd.
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended December 31, 2006
Business Overview: GRAVITY is a leading developer and publisher of online games, primarily based in Korea. Its principal product is the massively multiplayer online role-playing game (MMORPG) Ragnarok Online, which accounted for approximately 78.3% of total revenues in 2006. The company operates through a mix of direct operations in Korea, the U.S., Canada, Russia, France, and Belgium, and through licensing agreements with overseas operators in other markets.

Key Financial Metrics (Year Ended Dec 31, 2006)

Margins (2006):
- Gross Profit Margin: 56.7% (down from 70.0% in 2005)
- Operating Margin: -29.8% (down from -5.0% in 2005)
- Net Profit Margin: -54.4%

Material Changes vs. Prior Period

• Revenue Decline: Total revenues decreased by 23.3% to Won 40.96 billion. This was driven by a 30.1% drop in royalties and license fees and a 25.1% drop in subscription revenue, primarily due to the maturity of Ragnarok Online and increasing competition.
• Significant Net Loss: The company recorded a net loss of Won 22.27 billion, a substantial deterioration from the Won 3.03 billion loss in 2005. This was largely due to a full valuation allowance on deferred tax assets (Won 12.07 billion expense) and increased litigation charges.
• Unusual Items:
  • Litigation Charges: Won 4.65 billion recorded in 2006 related to securities litigation.
  • Proceeds from Fraud: Won 4.95 billion received from the former chairman as reimbursement for diverted funds.
  • Asset Disposal: A gain of Won 1.08 billion from the sale of the company's building.
• Mobile Games Growth: Mobile game revenues increased by 130.8% to Won 3.84 billion, largely due to the full-year impact of the NEOCYON acquisition.

Guidance, Outlook, Risks, and Contingencies

• Outlook: Management expects to continue deriving a substantial portion of revenues from Ragnarok Online for at least the next year. The company is developing Ragnarok Online II (expected launch Q3 2007) and Requiem to diversify revenue streams.
• Internal Controls: Management concluded that internal controls over financial reporting were not effective as of December 31, 2006. Four material weaknesses were identified, including lack of controls over revenue reporting from overseas licensees and insufficient accounting personnel. Remediation efforts are underway.
• Legal Proceedings: The company agreed in principle to settle a class action securities lawsuit for US$10 million (Company's share anticipated at US$5 million). The settlement is subject to court approval.
• Key Risks:
  • Product Concentration: Heavy reliance on Ragnarok Online (78.3% of revenue).
  • Licensing Dependence: 63.8% of revenue comes from overseas licensees; deterioration in relationships or licensee performance poses significant risk.
  • Regulatory Environment: Operations in China, Taiwan, and Korea face evolving regulations regarding content, internet cafes, and anti-addiction systems.
  • Geopolitical: Tensions with North Korea and political instability in Taiwan could adversely affect operations.

Important Facts for Investor Verification

• Revenue Concentration: Verify the sustainability of Ragnarok Online revenues given the 30% decline in royalties and the maturity of the game in key markets like Japan and Taiwan.
• Internal Control Remediation: Monitor the progress of remediation for the four identified material weaknesses in internal controls, particularly regarding revenue recognition from overseas partners.
• Legal Settlement: Confirm the final approval and payment terms of the US$10 million securities class action settlement.
• New Game Launches: Track the commercial performance and launch dates of Ragnarok Online II and Requiem, which are critical for future growth.
• Tax Status: Verify the company's continued eligibility for preferential tax treatment in Korea, as the expiration of this status could significantly increase future tax expenses.