Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Summary
Prima facie, Nexon possesses many attributes that are cat-nip to value
investors. However, if one delves very deeply, the situation is downright
ugly.
The Company's blockbuster games are facing severe structural dislocation.
Mobile revenue growth is misleading. When adjusted, the growth story
materially deflates.
Bulls seem to be enamored with pipeline-related extrapolations of future
growth that seem reasonable to the uninformed observer, but are wildly
optimistic in actuality.
The strategic logic of acquisition-driven growth sounds good at first, but
upon closer scrutiny, is deeply flawed. Negotiating leverage is
asymmetrically skewed to sellers.
In my view, a 7x P/E on an unsustainable business and no premium for the
early-stage VC nature of the Company's pipeline is reasonable. Limited
upside, ~40% downside.
Author's note: Nexon trades on the Tokyo Stock Exchange (TYO:3659) with much
greater liquidity. All discussion is in Japanese Yen, unless otherwise indicated. All
references to call transcripts and investor presentations are sourced from
Nexon's investor relations website.
Thesis
At first sight, Nexon (TYO:3659) ("Nexon", or the "Company") appears to
possess numerous attributes that are cat-nip to value investors - a fair (cheap
ex-cash) valuation, strong top-line growth and ballooning net profits, a
sustainable business model, a well-stocked pipeline of game releases/updates,
and a substantial net cash balance (~25% of market cap) to utilize as dry powder
for acquisitions, which also doubles as downside protection. After delving very
deeply into the Company, I came away unconvinced - I believe the situation is
downright ugly.
In my view, the Company's blockbuster games (MapleStory, Dungeon Fighters)
are facing severe structural dislocations in their current state due to numerous
development missteps. Mobile has been touted as an accelerant to the growth
story, but careful analysis reveals that is mobile sales growth misleading. Bulls
also seem to be enamored with pipeline-related extrapolations of future growth
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

that seem reasonable to the uninformed observer, but are wildly optimistic in
actuality as they neglect to account for user alienation, the competitive
landscape, and the inherent 'viral-ness' that a game requires to be successful.
While a substantial cash balance allows the Company to grow inorganically,
large acquisitions are likely to be value-destroying as its strategic logic is deeply
flawed. Negotiating leverage is also asymmetrically skewed to sellers, making it
difficult for the buyer to reconcile the economics of a deal.
Why now? Multiple reasons - a) despite a fast-growing top- and bottom-line,
growth appears low-quality, driven by unsustainable ARPPU expansion
offsetting declining MAUs - which when analyzed in conjunction with pay rates,
suggest a startling decline in 'real' users - and misleading mobile sales growth,
b) 2015 net income growth that has not been translated into cash generation and
was largely due to a tremendously easy comp thanks to a significant non-tax
deductible amortization charge in 2014, c) continued deterioration in gameplay
quality should serve to sustain or even accelerate the decline in MAUs, d)
persistent failure to gain any sustainable traction in core blockbusters despite
frequent game updates, which is unsurprising due to Wall Street pressures that
stems from Nexon's current status as a public company, e) revenue contribution
from 'growth' markets such as China and North America growing much slower
than 'mature' markets such as Korea, suggesting limited traction, and f) a muchhyped up launch of MapleStory 2 in China and Dungeon Fighters on mobile which
are highly likely to disappoint.
Quick Background
Nexon is primarily a developer of games. U.S.-based investors can arguably call
Nexon the Activision (NASDAQ:ATVI) of Asia. PC revenue is currently ~78% of
revenues. This is down as a percentage of overall revenues from ~82% in 2013,
due to ~20% growth rates in mobile revenues. Growth is driven largely by itemcharging sales, which accounts for ~60% of overall revenues - a number that is
growing quickly.
The Company's largest games are MapleStory (the first version, not the second MapleStory 2) and Dungeon Fighter, both of which contribute ~55% of overall
revenues or ~70% of PC revenues (source: 1Q '12 and 3Q '13 call transcripts).
Both games are 2D side-scrolling MMORPGs. Other PC games such as Mabinogi
likely contributes the rest of PC revenues.
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Note that Nexon does not formally offer a breakdown of revenue by game, thus we
have to rely on infrequent mentions by management. Regardless, this limited
information suffices for our purposes.
Geographic concentration is split as follows:

Source: 2015 Business Report

In short, it is clear that MapleStory, Dungeon Fighter, and other smaller games
does all the heavy-lifting, and mainly in Korea and China. Mobile is growing
faster than PC, which should not be surprising given the slow decline in PCs and
rapid growth in tablet/smartphone penetration. Item-charging sales is the
common growth denominator for all games, whether mobile or PC.
Item-charging sales are probably most aptly described as in-game equipment
power-ups that disproportionately strengthens the user's character.
Nexon's stock performed rather badly post-IPO (2011 to mid-2012) due to
declines in quarterly sales in its largest markets (China and Korea) and
uninspiring growth in its 'growth' markets of North America and Europe. Shares
have since more than doubled off its lows in late-2012.
This massive increase in valuation seems to be predicated on - 1) Nexon's entry
into mobile games 2) massive ARPPU gains despite declining MAUs, 3) a robust
pipeline which includes games whose prior iterations experienced huge success
(i.e. MapleStory), and 4) a growing cash balance that could be used for a large
acquisition.
Why Does The Opportunity Exist
Compelling headline metrics: On the surface, Nexon appears to be a firm with
a fast-growing top-line and inflecting bottom-line, as seen below.
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 2015 Business Report

The takeaways are: in 2015 Nexon saw ~10% top-line y/y growth and ~88% EPS
growth. Operating margins are ~32%, while net margins are ~29%.
In addition, Nexon appears cheap and safe - it sports a mid-teens P/E, which
turns into low-teens if one excludes net cash, and offers substantial downside
protection afforded by its sheer net cash position.
Moreover, Nexon appears to be a downright bargain relative to comps
(Activision, etc) who trade beyond a high-teens P/E multiple. Put this all
together, and value investors are likely salivating at a chance to own shares.
Robust pipeline to support future growth: Nexon's game pipeline is filled with
numerous upcoming releases. Perhaps the biggest release of all will be
MapleStory 2, which Nexon signed a publishing agreement with Tencent to
launch the game in China.
MapleStory (the previous iteration) has seen much popularity, largely in Asia
(disclosure: I was a long-time player). Bulls are likely betting on MapleStory 2
repeating a similar performance.
Dungeon Fighter is also set to be released on mobile in 2016. The PC version of
the game was hugely popular at one point, and longs seem to be extrapolating
that same success onto mobile.
Potential for acquisition-driven growth: The current CEO, Owen Mahoney,
was brought on with an implicit mandate to drive Nexon's growth inorganically.
This was unsurprising given that Mahoney was previously at Electronic Arts
(NASDAQ:EA) where he was SVP of corp dev and was tasked with handling global
M&A and business development. Armed with the Company's substantial cash

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balance, longs are likely hoping that Mahoney can augment growth with smart
capital deployment and huge transformational acquisitions.
Strong sell-side support: Nexon is currently covered by mostly bulge-bracket
banks such as Deutsche, Morgan Stanley, Nomura, Goldman, and many more.
Sell-side reports written by bulge-bracket banks tend to enjoy the widest
distribution amongst institutions. The reports that I was able to get my hands on
were largely bullish on the Company's current business and future prospects.
Most called the Company an 'extraordinary bargain', a 'top pick', and 'the best
risk/reward we have seen'.
Organic growth is largely unsustainable
Bulls cite the age of Nexon's largest games as the single most important evidence
of the durability of the business. MapleStory was launched in 2003. Dungeon
Fighters was launched in 2005. Longs assume that since these games are still
going strong years after their original inception, the games will be sustainable
in the future. Management is (unsurprisingly) also a huge supporter of this
sentiment, as seen below. The Company claims to emphasize game longevity,
player retention, and their highly differentiated nature.

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 4Q '15 Investor Presentation, emphasis mine

Source: 4Q '13 Earnings Presentation, emphasis mine

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 4Q '15 Earnings Presentation, emphasis mine

Seen above are the Company's 2012-2015 financials. Important takeaways are
- quarterly
ARPPU (average
revenue
per paying user) has
nearly
doubled(~80% increase) from 1Q '12 to 4Q '15 - over 16 quarters. MAU (monthly
average users, which excludes mobile users) has nearly halved over the same
period. Pay rate (paying users/MAU) has remained quite steady at ~10%.
In particular, the bull thesis seems to be predicated on the misguided belief that
ARPPU growth is structural in nature and is sustainable, which shows a complete
lack of understanding regarding the current MMORPG landscape and gameplay
quality.
The main allure of MMORPGs is two-fold - the grind and competition between
players.
When a player starts playing an MMORPG, things are interesting and milestone
achievements are very fulfilling. The primary reason why the game is fulfilling
is due to the grind. You spend many months leveling your in-game character in
order to gain access to new areas, skills, equipment, and other perks. When you
achieve said milestones, you feel a huge sense of achievement due to the sheer
level of effort you have put in.
Since the grind takes a long time, you invite your friends so that your game
characters can participate in group-only activities, which tend to be more
interesting and fun due to the group dynamic. This the central reason why
MMORPGs tend to explode once they reach critical mass - it is the network
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effect at play here. A larger user base equals a larger in-game community,
which attracts more new players as it is more interesting to game with many
other people.
With more players, you get competition between players (e.g. who reaches the
max level first, who obtains the best equipment first, etc). And in a competition,
people try to get ahead.
And the primary avenue that gamers turn to in order to get ahead of one another
is real-world trading. Soon after MMORPGs exploded, people started
programming bots to 'farm' in-game currency, equipment sets and weapons,
selling them in the real-world to those who did not want to spend the many
months required to reach these milestones. Perhaps the most famous example of
this phenomena would be Chinese farmers. Here is a video of an interview with
a professional Chinese gold farmer.
While in-game moderators can ban these bots, there is no stopping them due to
the low barriers to entry for botting - all you need is the software which
automates your accounts, after all. Botters are like a many-headed Hydra - cut
off one head, and two more grow in their place.
There has been interesting approaches taken by game developers to combat this,
but they have mostly failed. RuneScape, which is developed by Jagex, tried
something called a 'trade limit' which prevented a trade between players from
occurring if the items exchanged were not of similar value.
This stopped real-world traders for a while (as the typical real-world trade was
to transfer real-world money to the seller through PayPal while the buyer got his
purchases through an in-game trade), but they found ways around it by achieving
the 'fair' trade value by utilizing junk items that had limited in-game
functionality and thus were objectively worthless. Eventually, the trade limit
alienated the 'real' player base so much and that Jagex was forced to reverse the
change. See this article for more detail on the introduction and eventual
removal.
Where do real-world traders sell virtual currency and in-game equipment sets?
On the 'black market' so to speak, which tend to manifest as websites and forums
where users buy/sell accounts, game currency, virtual items, and more. The two
largest that I know of are Sythe and PlayerAuctions. Browse around these sites,
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and one would realize that botting is ubiquitous. Essentially, as long as a game
can be automated and is popular (thus there is potential for profit for botters),
you can bet that the botters will come.
Since there is no stopping botters (banning is ineffective - botters will just create
new accounts, and you can't legally restrict people from writing software),
MMORPGs have essentially been forced to adapt. How did they adapt? Well, if
you can't beat 'em, join 'em. Stated simply, the game developers were forced
to compete with real-world trading sites.
Game developers like Nexon recognized that players wanted instant gratification
and so they came up with micro-transactions, which manifest themselves ingame as a special shop where players can purchase virtual currency, items,
equipment sets, level-ups, boosts, etc in exchange for real-world money.
But as students of economics, we know that this is a fool's errand. With low
barriers to entry anyone with access to the software which automates gameplay
can do it. The first movers made loads of money doing it. Economics for the
botters were very compelling, after all. Very low fixed costs (computer, software,
electricity) and incremental sales (selling virtual currency, item sets, boosts, etc)
drops to the bottom line once you cover your fixed costs.
Once others found out how you could make a reasonable living doing this stuff,
they piled on. Since fixed costs are very low, the breakeven point is also low. As
a result, botters operate and undercut each other on price thus resulting in the
game's currency experiencing hyperinflation. Since there is no stopping
botters, game developers like Nexon have to make the best out of a terrible
situation. So they sold the same (and better) stuff the botters sold.
The power-ups gave players such disproportionately strong boosts and made the
game so easy that there was no enjoyment in it at all. Here are two MapleStory
videos (one, two) that illustrate my point perfectly.
In the first video, it shows upwards of twenty players fighting the boss. Notice
that the video skips some of the footage due to time constraints. As you get to
4:20 in the first video, you can clearly see the time taken to defeat the boss - the
health bar (top of the screen) drops very slowly, and the uploader just skips
portions of the fight. The full fight probably took hours (speaking from personal
experience). Also note that the player who recorded the video is level 147
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(bottom left of the screen). This was MapleStory boss-fighting 9 years ago (note
the upload date).
In the second video (fast-forward to 1:32), we see that it is possible to solo the
same boss and kill it within 8 minutes (there's a timer) as a lower-leveled
character (level 122) due to item boosts and other similar factors. It is simply
too easy. Note that the second video was uploaded 2 years ago. This is
MapleStory boss-fighting now.
The situation is similar in Dungeon Fighters as well, Nexon's 2nd most popular
game to date - videos one and two. This one shows the difference between
buying power-ups using real-world cash and not buying power-ups and simply
obtaining the items and boosts in-game (which were much weaker) through
traditional grinding. Both videos were uploaded in 2015, so it is a pretty fair
comparison to see the difference between 'paying-to-win' and not paying to win.
While not all players would engage in micro-transactions to pay to win, this does
not really matter. As long as a small subset of players do, it destroys the fun for
others because those who did not utilize pay-to-win have game characters that
are weaker than those who did by several orders of magnitude. When differences
become so great, free-to-play becomes pay-to-play - those who initially did not
pay-to-win would have to, in order to keep up.
To make things challenging for those who pay-to-win (and to appease their
largest customers), game developers create tougher bosses, leaving the average
player in the dust (they can't even beat the prior bosses, there is no chance they
can attempt the newer ones). These 'whales', players who spend thousands to
get the best equipment and become the strongest player in the game, eventually
wise up, stop playing, and try to sell their account through real-world trading.
ARPPUs increase massively because players are paying more to win. If you utilize
pay-to-win, the game eventually loses its lustre as it becomes too easy (or you
wise up to the game developers' scheme) - this significantly accelerates player
churn. This is central reason why I believe the growth in ARPPUs is
unsustainable - it is driven mainly by item-charging sales. Unsurprisingly,
rapidly-declining MAUs illustrate this trend.
The other thing that Nexon did to compete with real-world trading sites was to
significantly shorten the in-game grind. After all, if you browse the above-linked
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'black market' MMORPG sites, you will realize that a significant portion of realworld trading was people buying/selling accounts. Nexon (and others like it)
clearly thought that they could combat this by drastically reducing time required
to grind to certain milestones.
In 2010, Nexon revamped their most popular game, MapleStory, with a game
update they called Big Bang. Big Bang turned out to be a major strategic error.

Source: MapleWiki
The lower experience curve was the most significant change. When I played
MapleStory during the latter part of the first decade of this century, it took years
to obtain the max level. If you were a player and did the math (calculating
experience/hour at different training spots, maximizing potion boosts to
increase damage output, finding the quickest route to re-stock on potion
supplies, etc), you could max under a year if you played 16 hours a day.
If you were a more normal player playing 4 hours or so a day, it would take you
many more years to reach the max level. The Big Bang patch made it possible
to get from 1-200 in under a month, playing a couple of hours a day.

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Undoubtedly, this obliterated the motivation of users. Reaching level milestones

were no longer as gratifying, as many other players were also at max level.
Obtaining the strongest equipment sets also brought you zero bragging rights everyone else could obtain them fairly easily. The original allure was exclusivity
- being the best-equipped, highest-leveled character brought bragging rights and
an immense sense of achievement. Now, given the ease of obtaining these
milestones, everyone could arguably be called the best. And when everyone is
the best, no one is.
Couple this huge change with the introduction of micro-transactions, and you
realize that the average user no longer finds the game enjoyable anymore, and
they quit very quickly, drastically reducing the average customer life for Nexon.
This quitting sets off the network effect - in reverse, as seen in the declining
MAUs discussed above. Less players equals smaller community equals less interplayer interaction equals less fun, rinse and repeat.
Now, the MAU numbers provided by Nexon is not the entire story. Consider this:
MAUs continued declining rapidly over 16 quarters in spite of numerous game
updates, new game releases, etc. Put simply, new game update/releases are
hiding massive player churn as they offer one-time spikes in the player base
which makes the actual situation much uglier than the headline metrics let
on. As seen in the slides below (and slides above which show quarterly revenue
breakdown), revenue spikes - which appear to be getting weaker - coincide with
new game updates. Here is the '13/'14/'15/'16 pipeline:

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 4Q '12 Earnings Presentation

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 4Q '13 Earnings Presentation

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 4Q' 14 Earnings Presentation

Source: 4Q '15 Earnings Presentation

There is a fair bit to chew on here. First, if you check the timing of game
updates/releases, you'll find that it coincides with one-time quarterly revenue
spikes, which support my prior assertion that updates/releases are hiding
massive player churn. While the Company might counter that this is just
seasonality at work, the fact remains that the sales contribution per
release/update has fallen drastically.
Second, if you look at the amount of releases/updates over the 2013-2016 period,
you'll find that the number of releases/updates have increased exponentially.
Even with a huge increase in game releases/updates, MAUs are still heading
down. This is unsurprising when you consider that the huge increase in
game releases/updates dilutes the quality of each new release/update. It
takes time for developers to come up with high-quality content that would please
players and increase MAUs, but time is simply not a privilege given to Nexon due
to its status as a public company.

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

The Street wants to see revenues and earnings grow every quarter, and thus the
only way to do that is to accelerate game releases/updates while massively
diluting the quality of each incremental release/update, significantly lowering
gameplay quality. As long as Nexon is a public company, it'll be forced to either
take this route and show growth every quarter, or disappoint the Street but reset
expectations. Both scenarios are not good for longs (but are good for shorts).
Third, if look at the countries where Nexon has released new games and updates
over the years, you'll find that the majority of these launches have been in Korea
and China. Therefore, if you scroll up to the slides where I show quarterly
revenue break-down by country, and look at Japan, you'll get a sense of how nondurable the Company's business model really is - sales in Japan has been
declining for 20-40% y/y in recent years. As a result, you can quite readily
deduce that if not for more frequent game releases/updates in other regions, you
would see massive revenue declines and dramatic player churn.
It gets worse. MAUs is calculated by taking the number of players that have
logged on once or more in a month. It does not differentiate between bots and
'real' (i.e. non-bots) players. As discussed, botting is rampant across many
MMORPGs. Obviously, game developers like Nexon will never divulge the
bot/non-bot breakdown to investors, but botting is rampant - just google
"MapleStory banning spree".
There is a way to get a proxy of the magnitude of 'real' players - by looking at
the pay rate. As discussed, the pay rate has remained relatively steady at ~10%
over much of the Company's history. According to Nexon, pay rate is calculated
as follows: number of paying users / MAUs. Mathematically, with declining
MAUs and a steady pay rate, this means that the number of paying users have
dropped substantially.
Since Nexon's games are free-to-play, paying users are quite a good proxy of
'real' players - real players will pay for in-game micro-transactions, botters
won't. So bulls may look at recent quarterly MAU numbers and conclude that
they might be potentially bottoming, but this is misleading as it neglects that the
lifeblood of Nexon - paying users - are disappearing rapidly.
This phenomena is not limited to Nexon. It is the result of a structural dislocation
in MMORPGs brought on by the presence of botters and real-world traders.
RuneScape hit 200m user accounts in 2012. During that time period, peak player
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count at any one time was ~100k if my memory serves me right. Lets multiply
that by 10 to get the active player count. Now, one may argue that it is normal
for one player to have 3-5 accounts (after all, you may want to try training and
equipping your character differently), but you would be hard-pressed to argue
that it is reasonable for each player to have 200 accounts - which is what the
200m user account number implies. The only explanation, of course, is that the
majority of user accounts belong to botters/real-world traders.
What about mobile? It seems fair to discuss mobile given that mobile sales grew
~48% y/y while PC sales declined ~4%. As discussed, the Company's entry into
mobile in late 2012 (see below) coincided with the stock beginning to recover
and eventually double off its lows - bulls are clearly counting on mobile as one
lever to drive future growth here.

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 4Q '13 Earnings Presentation, emphasis mine

Yet, mobile sales growth is misleading. Nexon entered the mobile space in a large
way in 4Q '12 - quarterly mobile revenue jumped over 10x to $7b due to a large
acquisition. At the same time, PG fees (payment gateway fees) nearly tripled, as
seen above.

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Source: 4Q '15 Earnings Presentation, emphasis mine

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Fast forward to 2015, quarterly mobile sales have just barely doubled from 4Q
'12 (from $7b to ~$13b) but PG fees have nearly tripled (from ~$2b to ~$5.7b),
as seen above. As PC revenue grew by a much smaller amount during that period,
we intuitively know that the rapid growth in PG fees was due to mobile.
Per the Company's 4Q '15 presentation, footnote 5 states that PG fees include
commissions paid to Apple/Google on their native games globally. Both Apple
and Google take 30% commission on any mobile revenue generated (see their
respective links). By including this 30% commission in their PG fees, this
suggests that the amount was not deducted to arrive at the revenue
number (or else there will be double-counting). Thus, mobile sales growth is
misleading. Ideally, the 30% commission should be netted off to arrive at
revenue.
As seen above, Nexon reported overall quarterly revenue growth of ~7% in 2015.
If we make the above adjustment for mobile, this number quickly turns ugly.
Now, I am not arguing for ignoring mobile, but investors should note that mobile
growth is not what it seems. Moreover, mobile is still 20% of sales and has lower
margins vs PC. Although the segment is growing quickly, it is unlikely to offset
a decline in PC, in the event there is a decline.
What about 'growth' markets such as North America and Europe? Well, they
aren't too compelling either. Here are the numbers for 2015.

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Source: 4Q '15 Earnings Presentation, emphasis mine

We see North America and Europe & Others growing at ~50% at ~80%
respectively. Sounds great, except both geographic segments are 1/10 of the
revenue generated in Korea. Korea grew 20%. At 1/10 the revenue, you would
expect growth rates in NA and Europe & Others to be far greater - something like
doubling/tripling every year, but this is not the case.
The grossly insufficient growth speaks to the lack of traction Nexon has in the
West. It is no secret that Western markets are far larger than Korea, and thus
this lack of traction speaks volumes of the Company's inability to get establish a
strong presence in Western markets.
Future growth - pipeline and M&A - is suspect
What about the Company's pipeline? MapleStory 2 is set to launch in China in
2016. Bulls are likely betting on MapleStory 2 replicating the success of its
predecessor. Yet, pipeline-related extrapolations of future growth is a ridiculous
assumption.

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Why? The reason is a simple one. The success of each game is independent
of the success of other games. This is evident if you look at Nexon's pipeline
over the years. The Company has developed many games, and yet most of these
games crashed and failed. Only a couple became huge successes. This reveals a
basic truth of the gaming industry - players do not play games just because it
was developed by Nexon (or Activision, Valve, EA or whoever), they play the
game because the game itself is fun and interesting. This becomes obvious when
you consider that game developers tend to have a portfolio of games that are
'top-heavy' - i.e. a few extremely successful games contribute 99%+ of the
revenue.
This is not limited to Nexon. Here is a list of games Activision, arguably one of
the leaders in the gaming industry, have developed over the years. Activision's
portfolio is similarly top-heavy as well - the firm generates a disproportionate
amount of its revenue from extreme successes like World of WarCraft, Call of
Duty, Skylanders, and Destiny.
Seen this way, being a game developer is very much analogous to being an earlystage VC. You stick your fingers in hundreds of pies, and hundreds of them will
lose money, but you hope that one or two of them are the next Facebook or
Google.
Bulls may argue that marketing the game would help. It certainly does, but only
in the initial stage. Nexon implicitly admits this if you look their at marketing
spend - marketing expense was ~7% of revenues in 2015. Activision is flushed
with cash to spend on marketing campaigns. Yet, most of the games they
developed over the years crashed and burned.
The verdict - marketing does not make much of a difference in the ultimate
success of the game. If it did, Nexon, Activision, and other large game developers'
hit-rate would be much greater. Word-of-mouth marketing, the cheapest yet best
form of marketing available is what determines a game's ultimate success.
Gamers play games because other people play them - this forms the basis of the
network effect.
The Company's 2016 pipeline has MapleStory 2 launching in China and Dungeon
Fighters launching on mobile. Bulls (and the sell-side) appear to be extrapolating
the success of prior iterations onto newer versions. Not only does this

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extrapolation fail to account for the low hit-rates that game developers
experience, it also neglects to consider other important factors.
One of these factors is increased competition. MapleStory (the first iteration)
and Dungeon Fighters (the PC version) are 2D side-scrolling MMORPGs.
MapleStory 2 is the 3D version of MapleStory. 3D MMORPGs are widespread and
have many more competitors than 2D MMORPGs (how often do you see a 2D
MMORPG?). Casual browsing of MMOHuts, a YouTube channel which reviews
new MMORPGs will lead you to conclude that the 3D MMORPG space is extremely
crowded. Couple that with Nexon's low hit-rate even in 2D MMORPGs, and the
Company's chances are not looking too good.
The mobile version Dungeon Fighters is going up against mobile MMORPGs,
which is also an extremely crowded space (just search for games on your iPhone
and see for yourself). Same conclusion as MapleStory 2 here. Moreover, the
Dungeon Fighters hype appears to be dissipating rather quickly, as seen below.
Therefore, even if one assumes that the PC player base will transfer over to
mobile, there are not many players to transfer over.

Source: Google Trends

The second factor is user alienation. It is fair to say that most MapleStory players
have spent a lot of time and effort on the first iteration of the game. By assuming
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

that a majority of that player base will transfer over to MapleStory 2 means that
you are assuming that these players will simply give up their hard work and time
spent on the first iteration - not exactly a reasonable assumption.

Source: Google Trends

MapleStory 2 was first launched in Korea, and as seen above, the hype quickly
went away - certainly not a sign of sustainability. The spike in interest probably
speaks to players testing out the new game, but the subsequent drop suggests
that they did not find the game interesting. With MapleStory 2 being a flop in
Korea, it is hard to see it succeeding in China.
User alienation is not limited to Nexon. Jagex released an extreme makeover of
RuneScape in 2012 called Evolution of Combat. There were many major changes
but none more significant than the introduction of 'action bars'. Basically,
RuneScape's traditional point-and-click gameplay was replaced with 'buttonmashing', similar to World of WarCraft, to utilize abilities.
If you read the wiki link, you'll notice that players balked at the change. While
actual numbers were not provided, former RuneScape players will tell you that
pre-EoC, peak player count was ~200k. Post-EoC, peak player count struggled to
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

hit ~100k. The loss of players was so significant that Jagex was forced to
reintroduce the old system after ~450k players voted for it, which they
termedOld School RuneScape.
What about M&A? Simply put, the strategic logic of M&A from the buyer's pointof-view is seriously flawed. It really is a chicken-and-egg problem.
Sellers will only sell their games in two scenarios - when their game is a success
and when it is not a success. While I recognize that buyers may purchase a game
that is still in development, this practice is analogous to merely capitalizing R&D
instead of expensing it and it faces the same troubles that other games do (i.e.
low hit rates).
The strategic rationale that buyers bring to the table is that they have the cash
to finance marketing campaigns and can provide access to distribution channels.
This is a compelling proposition to a seller of a game which is unsuccessful.
However, as discussed above, company marketing is not a huge factor in
determining the ultimate success of a game. In this situation, it is very
compelling for the seller, but not very compelling for the buyer.
Buyers want to buy games that are successful, but sellers of successful games do
not need these buyers. Buyers provide company marketing and distribution, but
by definition, successful games do not need these - they are already successful
and presumably can finance their own marketing and negotiate their own
distribution deals. The only thing sellers need from buyers is to cash out. As
buyers bring nothing to the table in this situation (their marketing and
distribution spiel is not compelling to the seller of a successful game),
negotiating leverage is asymmetrically skewed to the sellers. Any deal
negotiated between the buyer and seller will result in the seller getting the upper
hand over the buyer.
This is not mere conjecture. A perfect example is Activision's purchase of King
Digital, the makers of Candy Crush. Activision was looking to reinvigorate
growth as World of WarCraft subscribers (which contribute a disproportionately
high percentage of sales) were declining. King Digital only sold itself to
Activision after their full-year financials showed a huge ~10% drop in 2015
revenues.

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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

At a $5.9b purchase price, some might argue that Activision got King at a cheap
price as King's 2015 net income was ~$500m, implying a ~12x multiple. But this
is misleading as King was an extremely high-margin business - EBITDA margins
were ~40%. As a result, a majority of the percentage of the drop in revenue falls
to the bottom line. As noted, King's revenue was declining at double-digit rates.
The fact that Activision was forced to pay ~2.5x sales and ~12x net income for a
rapidly declining business only goes to show how poor of a negotiating position
it was in.
With negotiating leverage heavily tilted in the favor of sellers, it is hard to see
Nexon ever successfully negotiating a large transaction where the economics
would make sense to them.
Incidentially, given Nexon's large cash balance that is presumably earmarked for
acquisitions (cash that is set aside for dividends is allocated to the capital surplus
account), it is not surprising to see such strong sell-side support for the
Company. After all, investment bankers want juicy M&A mandates and therefore
investors should take their views with a grain of salt.
Valuation - limited upside, ~40% downside
So what would a rational buyer pay for a business whose organic growth is
unsustainable, future organic growth is literally analogous to early-stage VC, and
future inorganic growth that is likely to be value-destroying?
I'd argue that a generous price would be no more than 7x net income. Ex-net
cash, Nexon currently trades at a ~12x P/E on 2015 net income. Therefore,
uninformed buyers likely think they're getting the base business for 12x and
paying nothing for the pipeline and future M&A. Informed buyers (i.e. those who
read this report) would be paying 7x for the core business and 5x for the pipeline
and future M&A.
As discussed, paying 12x for an unsustainable business is simply ludicrous. So
that leaves paying 7x for the core and 5x for the pipeline and M&A. However,
given the moonshot nature of the pipeline and the unlikelihood of accretive M&A,
a rational buyer would probably insist on getting the pipeline and future M&A as
free options on the upside. You might even argue that since M&A will likely be
value-destroying and management seems to want to grow through M&A (they
hired a deal guy as CEO), you might need a further discount.
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

Bulls probably think that upside could come from multiple expansion. After all,
Activision currently trades at ~24x P/E ex-net cash. Easy double from here if
Nexon trades at a similar multiple, right?
Not so fast. The reason why ATVI trades at a huge premium to Nexon is simply
because Activision's largest franchises are much more sustainable than Nexon's.
Per its most recent 10-K, Activision's most successful games are Call of Duty,
World of WarCraft, Skylanders, and Destiny, all of which collectively accounted
for ~71% of 2015 sales, and a significantly higher percentage operating income.
The reason why ATVI's business is much more sustainable as compared to Nexon
is because micro-transactions does not make much of a difference between those
who use it and those who do not. Additionally, the botting/real-world trading
problem, which mainly occurs in World of WarCraft, is somewhat mitigated due
to the simple fact that every WoW player (bot or not) needs to pay a monthly
subscription fee to Activision. In gaming history, WoW is an extreme outlier in
that the quality of the game was so compelling that players were willing to pay
a monthly subscription fee just to play the game. Nexon and others have yet to
come up with a game of similar quality.
Moreover, unlike Nexon, WoW and CoD does not suffer from the lack of interest
once players have completed all major milestones. The reasoning is simple these games are skill-based in the later stages of the game, not grind-based.
There are even real-life competitions where teams compete for cash prizes
(WoW, CoD). Many players practice for years (resulting in franchise
sustainability for ATVI) at a chance to enter these competitions - the potential to
win prizes/bragging rights is the fuel motivating them here.
As a result, analysts who are unaware of these nuances would mistakenly believe
that Nexon is undervalued vis-a-vis its apparent 'peers'. With the 'undervalued
relative to peers' argument shattered, it seems hard to argue for any upside for
Nexon here, given that you are either paying (if you agree with my estimates)
7x for an unsustainable business (fair) and 5x for a early-stage VC pipeline
(insane), or 12x for an unsustainable business (insane) and zero for the pipeline
(fair).
As discussed, revenue was up ~10%, operating income up 30%+ and net income
up ~90%. However, the 30%+ and ~90% jump in operating and net income
respectively is not as impressive when one considers that it was driven by a
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

massive reduction in the tax rate (from ~44% in 2014 to ~17% in 2015) and a
~$10b cut to other expenses.
Management does not offer a detailed explanation in the 2015 Business Report,
but its comments on the earnings call suggest that these oddities stemmed from
a non-tax deductible amortization charge in 2014 which depressed net income
(and thus elevated the tax rate due to non-tax deductibility). In other words,
Nexon had an extremely easy y/y comp. Moreover, while net income burst
through the gates, cash from ops only increased ~4%, suggesting that much of
improvement in net income has not actually generated cash.
While revenue was up during the year, it was largely due to ARPPU gains which
are unsustainable, in my view. The Company's transition to mobile has also
pressured margins due to mix (mobile has lower margins) - gross margins have
fallen from ~83% in 2012 to ~74% in 2015 while operating margins have fallen
from ~35% to ~29%. Management also guides to increasing expenses related to
marketing and headcount, making it difficult to argue for anything but negative
gross or operating leverage going forward.
With declining margins, even if Nexon repeats its 2015 top-line performance
(~10% growth), net income would probably only rise by mid single-digits at best.
As mentioned, it is also doubtful that net income would translate to cash
generation. ~5% growth over 2015 gets you to ~$55m in net profit. On these
numbers, Nexon trades at a ~15x P/E discounted back one year at a 10% rate.
Ex-net cash, the multiple is closer to 11x. Assuming a contraction to 7x, shares
see ~40% downside.
Note that when it becomes evident that ARPPU is unsustainable (i.e. revenue
starts to fall), combined with higher expenses, net income would drop like a
shoe. Thus, the Company's current multiple could expand fairly quickly through
a substantial earnings decline, widening the potential multiple contraction.
Catalysts

Further increases in ARPPU and deterioration in MAUs - as discussed,

increases in ARPPU would only serve to accelerate player churn, and the
deterioration in MAUs would sustain negative network effects. Nexon is
essentially milking their blockbusters for all they are worth, which is fine, but
you should neither pay 12x for that nor extrapolate based on the age of games
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

that they will be sustainable in the future - which is what longs are essentially
doing at the current price.

MapleStory 2/Dungeon Fighters flops - as discussed, both MS2 and DF mobile

are launching in 2016 and are, in my view, highly likely to be unsuccessful due
to the inherent low hit-rates for game developers and the effects of increased
competition (3D MMORPGs for MS2, mobile MMORPGs for DF) and user
alienation. The MS2 launch in Korea was not successful, for what's its worth.

Mobile losing steam - as discussed, Nexon's entry into mobile is likely one
major lever of growth that bulls are counting on, but mobile is a hypercompetitive arena, meaning that it is difficult to gain significant traction in
any one game, and even more difficult to sustain said traction once it is gained.
Case in point: Candy Crush was a mobile blockbuster for a couple years, but
the hype is rapidly fading (see King's financials).

Overpaying for a large acquisition - as discussed, due to the chicken-and-egg

problem, in the event that Nexon embarks on a huge acquisition, it is very
likely to be forced to overpay as it brings nothing valuable to the table. Thus,
negotiating leverage is asymmetrically skewed to the sellers. Overpaying for
a large acquisition would also significantly reduce downside protection in
shares due to a large cash outflow.

Risks to the short thesis

Reversal in MAU decline (i.e. MAUs begin growing). Mitigant: It is hard to

envision such a scenario occurring, given that despite many new game
releases/updates over Nexon's public-company life, there has been no signs of
the MAU decline stopping. The inherent low hit-rate of game developers also
make betting on a MAU reversal an unattractive proposition.

MS2/DF is a huge success/mobile gains significant traction. Mitigant: As

discussed, MS2 is a 3D MMORPG. Even assuming success, a successful
MMORPG will attract the presence of botters/real-world traders due to the
potential for them to profit off real-world trading. Real-world trading takes out
all the fun and leads to hyperinflation in the game economy and hence, even if
MS2 is a success, the success is likely to be short-lived. As for DF mobile, microtransactions will provide disproportionately strong power-ups (similar to the
PC version) for those who pay-to-win and this would lead to a similar result as
MS2. This applies to other mobile games as well.
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Short Nexon (TYO:3659) | Lester Goh, 15 April 2016

A large acquisition resulting in an initial spike in shares. Given that Nexon has
made it clear that growing through M&A is one leg of the Company's growth
strategy, making a large acquisition could probably validate the Company and
provide an initial spike in the share price. Mitigant: However, as discussed,
any large acquisition is likely to be value-destroying due to the sheer difference
in negotiating leverage between Nexon and potential sellers. Therefore, the
spike in shares would likely be temporary.

A buyout. Mitigant: In my view, it is very clear that the core business of Nexon
is unsustainable. Therefore, there appears to be little reason why an acquirer
would consider Nexon a take-out candidate.

Conclusion
In my view, Nexon exhibits many attributes of a compelling short - 1) an
unsustainable core business; 2) a pipeline that resembles early-stage VC
investments; 3) a M&A strategy that is highly likely to be value-destroying; and
4) drastic overvaluation due to investors either overpaying for the unsustainable
core business or the pipeline. Shares should see ~40% downside as the
aforementioned points become evident over the next few quarters.
Disclaimer: The author's reports contain factual statements and opinions. He derives factual
statements from sources which he believes are accurate, but neither they nor the author represent
that the facts presented are accurate or complete. Opinions are those of the author and are subject
to change without notice. His reports are for informational purposes only and do not offer
securities or solicit the offer of securities of any company. Mr. Goh ("Lester") accepts no liability
whatsoever for any direct or consequential loss or damage arising from any use of his reports or
their content. Lester advises readers to conduct their own due diligence before investing in any
companies covered by him. He does not know of each individual's investment objectives, risk
appetite, and time horizon. His reports do not constitute as investment advice and are meant for
general public consumption. Past performance is not indicative of future performance.

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