Pan-Asia Internet and Online Games

Korea Information Technology 11 July 2018

Initiation: AI — what if characters played like humans?

 Harnessing AI technology to provide more immersive gameplay  Implementation of AI looks set to have a positive impact on gamer experience, retention, and monetisation  Initiating with a Positive sector stance; our top pick is NCsoft, where we expect AI to boost ARPUs and lengthen game life cycles Thomas Y. Kwon (82) 2 787 9181

[email protected]

See important disclosures, including any required research certifications, beginning on page 60

Korea Information Technology 11 July 2018

Pan-Asia Internet and Online Games

Initiation: AI — what if characters played like humans?

[email protected]

What's new: In our view, there are 2 forms of artificial intelligence (AI) Key stock calls systems in the ICT industry: 1) smart AI, which helps to solve problems, New Prev. and 2) emotional AI, where the goal is to act and think like a human. From NCsoft (036570 KS) our on-the-ground discussions with AI experts in Korea, we believe the Rating Buy Buy game sector is best positioned to use AI to enhance core business value, Target 515,000 470,000 realise cost efficiencies, and create new business opportunities in 2018-20. Upside p 33.2% Netmarble Games (251270 KS) What's the impact: AI at play. A perfect storm of AI evolution has hit the Rating Buy Buy Internet and Online Games Sector, amplified by Big Data, growing Target 188,000 171,000 Upside p 15.3% computing power, and the sharing of a vast knowledge base. We expect Nexon (3659 JP) the leading game developers in Korea to leverage AI technology for core Rating Buy Buy game services to improve deep learning algorithms, and for use in Target 2,150 2,200 advanced gaming devices, virtual reality (VR), and 5G. Upside p 28.4%

Source: Daiwa forecasts Data is everything in AI adoption. Korea’s game industry has better data assets for use in an AI system than any other industry, in our view, as it generates well structured, interactive, and scalable data in real time. We expect AI-supported applications to help game companies increase core- business value, cut costs, and boost earnings from 2H18. We think these AI platforms give game companies a competitive advantage, as such platforms are hard to duplicate or even benchmark in the short term.

Solid momentum in AI monetisation. With the “gamer experience” continuing to improve, game companies stand to benefit from rising item transactions and solid revenue as game service cycles lengthen, in our opinion. We look for AI-enabled platforms to help lower the cost of retaining gamers, operating game services, and developing new titles. As a result, we expect the leading game companies in Korea to see strong earnings growth and reratings as their AI investments start to pay off in 2019.

What we recommend: We initiate coverage of the sector with a Positive stance. NCsoft (036570 KS, KRW386,500, Buy [1]) is our top pick, due to its AI expertise and improving visibility on new game launches. Through ongoing AI R&D initiatives, we believe Netmarble Games (251270 KS, KRW163,000, Buy [1]) and Nexon (3659 JP, JPY1,675, Buy [1]) will leverage AI to help retain gamers and control operating costs. We raise our TPs for NCsoft and Netmarble by 9.6% and 9.9%, respectively, after revising up our 2019E EPS; but we lower our TP for Nexon by 2.3% after cutting 2019E EPS by 2.5%. Key risks: surging labour costs, privacy issues, and data security.

How we differ: This is the first research report to analyse the core AI strategies of the leading game developers in the Pan-Asia region.

See important disclosures, including any required research certifications, beginning on page 60

Pan-Asia Internet and Online Games: 11 July 2018

How do we justify our view? Growth outlook Valuation Earnings revisions

Growth outlook Global: top use cases of cognitive and AI systems (2016-21) IDC forecasts spending on cognitive and AI systems in 91.2% Asia Pacific (ex-Japan) to expand at a CAGR of 69.8% 88.4% over 2016-21 to USD5.0bn in 2021. The industry research firm expects the adoption rate of cognitive and AI systems 85.0% in the region to accelerate from 2018, on the back of 82.2% increasing demand for automated customer services, 81.6% intelligent processing automation, expert shopping 66.4% advisors, and digital assistants. Expert shopping advisors and product recommendations Automated claims processing Intelligent processing automation Digital assistants for enterprise knowledge workers Merchandising for omni channel operations, supply and logistics Others Source: IDC forecasts, Daiwa

Valuation Global: peer-comparison valuation (2018E) Amid concerns over mounting costs for marketing and -35.0 -25.0 -15.0 -5.0 5.0 15.0 25.0 35.0 game development, the PERs of game companies in Netease* 4.2 14.5 Tencent Holdings* 8.2 26.4 Korea hovered around 12-15x in 2015-17. But we expect Activision Blizzard 5.3 20.2 industry leaders like NCsoft to have greater visibility on Electronic Arts 8.3 18.7 Cyberagent 9.0 17.5 revenue streams and earnings from 2018, supported by Mixi 1.1 1.2 Square Enix 2.9 9.5 effective monetisation on the back of AI-assisted content Colopl 1.3 4.0 and improving efficiency in game operations and game Konami Holdings 2.6 9.2 Nexon* 2.5 8.7 development. In our view, these developments could yield Pearl Abyss 5.9 9.8 Kakao* 1.8 19.9 a valuation rerating for the leading Korean game Com2uS* 2.4 6.2 companies in the coming years. NCsoft* 2.6 8.7 Netmarble Games* 2.9 16.4 PBR (X) EV/EBITDA (X) (15) (5) 5 15 Source: *Daiwa forecasts, Bloomberg consensus Note: based on 10 July 2018 closing prices

Earnings revisions Global: share-price performance vs. EPS revisions

The Bloomberg earnings consensus estimates for the 20 3M price return Korean game developers were revised down following (%) companies’ 1Q18 results announcements, due to a rise in 0 labour costs, delays in new game launches, and a fall in game sales of core mobile games in Korea and Asia. However, we expect these companies to see a solid (20) revenue and earnings growth cycle from 2H18 through to 2020, driven by revenue contributions from new (40) 3M consensus EPS change (%) blockbuster mobile games, service-region expansion -30 -20 -10 0 10 20 30 Netmarble Games* NCsoft* Com2uS* Kakao* overseas, and stable operating costs due to effective cost- Pearl Abyss Nexon* Konami Holdings Colopl cutting initiatives driven by AI platforms. Square Enix Mixi Cyberagent Electronic Arts Activision Blizzard Tencent Holdings* Netease* Source: Bloomberg consensus Note: based on 10 July 2018 closing prices

Pan-Asia Internet and Online Games: 11 July 2018

Sector stocks: key indicators

EPS (local curr.) Share Rating Target price (local curr.) FY1 FY2 Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. % chg NCsoft 036570 KS 386,500 Buy Buy 515,000 470,000 9.6% 23,287 25,444 (8.5%) 32,393 32,044 1.1% Netmarble Games 251270 KS 163,000 Buy Buy 188,000 171,000 9.9% 5,724 6,065 (5.6%) 7,318 6,843 6.9% Nexon 3659 JP 1,675 Buy Buy 2,150 2,200 (2.3%) 117 122 (4.4%) 122 125 (2.5%) Source: Bloomberg, Daiwa forecasts

NCsoft: schematic architecture of B&S AI (2.0) NCsoft: AI Centre organisational chart

Source: Company Source: Company

Pan-Asia Internet and Online Games: 11 July 2018

Table of contents

Investment conclusions ...... 5 AI adoption: a solution for innovation ...... 8 Korea: the AI wave is coming ...... 14 Clash of the titans: race for market leadership ...... 17 AI: enhancing earnings power in the long term ...... 18

Company Section NCsoft ...... 21 Netmarble Games ...... 33 Nexon ...... 45

Pan-Asia Internet and Online Games: 11 July 2018

Investment conclusions

The best-placed industry to evolve with AI technology It is challenging to We believe the Pan-Asia Internet and Online Games Sector is one of the best-placed incorporate AI into segments to capitalise on the opportunities created by AI. Compared with other industries, games, but … we believe the game industry is better positioned to build a database of customer interactions – gamers, their gameplay, in-game commerce, payment data, and even customer services used. These datasets are well structured and available on a real-time basis, allowing for quick monetisation through various uses of AI.

In our view, the game companies have a strong knowledge of their core businesses, implying that they can easily identify problems, develop trial versions of games, receive and interpret feedback, and launch new services and products. We believe that key advantages for the game industry in utilising AI technology include: the ability to receive and digest feedback from consumers quickly, a well-controlled ecosystem, an easy-to- apply database, and the ability to utilise vast amounts of log files generated by gameplay.

… there are 3 factors Arguably the 3 main factors propelling the ongoing adoption of AI in games are: 1) the driving rapid adoption of availability of Big Data, 2) massive computing power, and 3) knowledge sharing through AI the use of open application programming interfaces (APIs). Data is not only about scale, of course – it needs to be relevant and meaningful. Despite the improvements being made to sensing technology and storage systems, there is still a gap between theoretical performance and practical reality in terms of AI. Hence, we believe that strong data sets and software expertise are critical considerations when implementing an AI platform.

The steady improvements in the computational power of distributed processing systems over recent years have helped AI to implement complex algorithms. More importantly, unsupervised deep learning algorithms have significantly improved AI capabilities to support various applications. With these more powerful deep learning algorithms, AI systems have become useful in systematically extracting core information from large data sets and applying this information to such areas as image processing, voice recognition, and natural language processing.

Enhanced game content We expect AI In our view, the onus is on the game companies to come up with smart strategies in terms implementation to of gamer acquisition and new game promotion, and offer customised monetisation models, enhance core game especially for mobile games where they currently offer free-to-play game services with services and yield new micro-billing for item commerce. We believe AI technology will be a key factor in making business-growth the game companies’ strategies even more targeted and efficient. At the same time, the initiatives companies can harness their AI systems to make in-game characters display more human- like behaviour, which should boost the overall gameplay experience.

We think the global leaders in massively multi-player online role-playing games (MMORPG) are particularly well positioned to capitalise on emerging AI technology, by leveraging their industry expertise, databases and platforms, diversified user bases, and large pools of talented software engineers. Furthermore, we believe that companies with AI acumen will continue to lead the competition, as it is difficult to duplicate AI platforms and catch up with a competitor’s substantial AI investment within a short period. Thus, AI can help these companies stand out from their peers and provide compelling game content.

We expect the game companies to implement enhanced AI systems as they continue to sharpen various algorithms and take into account their own business requirements. For example, these companies can identify the best use case for AI for each business division, including marketing, customer services, and R&D. We highlight that AI goes far beyond the games themselves – it should be an underlying technology for all work processes, as it can provide solutions, improve work procedures, and help to increase a company’s core value.

Pan-Asia Internet and Online Games: 11 July 2018

Going forward, we expect that all divisions within a game company will deploy AI in a bid to enhance productivity and efficiency.

More positives than negatives over the long term Valuation In our view, the rapid adoption of AI in the game industry could lead to an increase in R&D expenses, as applications are limited for now. Hence, investors may be concerned about a weak profitability outlook for 2018-20 as a result of the increased headcount needed to drive AI initiatives. However, we believe AI technology will help game companies move up the value chain in game development and game services by: 1) saving on R&D costs in the long term, 2) improving the gamer experience, 3) extending the life cycles of games, and 4) most importantly, lowering operating costs. For example, the use of AI systems may help game companies to cater to the rapidly changing working environment in Korea, where a new law caps the working week at 52 hours (40 hours for weekdays, plus 12 extra working hours), including overtime (effective from 1 July 2018), potentially leading to higher labour costs for domestic corporations.

Likely due to the concern over mounting costs for marketing and game development, the valuation multiples of the Korean game companies hovered at around 12-15x PER in 2015-17. However, we expect these companies to have better revenue and earnings visibility for 2018-20, supported by the effective monetisation of AI-assisted content and improving efficiency in game operations and development. In our view, these developments could result in share-price reratings for the leading game companies over the long term.

NCsoft is our top sector NCsoft is our top pick in the Pan-Asia Internet and Online Games Sector, as we believe pick this leading game developer will benefit from its investment in AI and related technologies by launching more standout games with dynamic gameplay. Also, we look for the company to see improving profitability over 2018-20 against the backdrop of stable operating costs, strong cash flow generation from franchise games, and the potential to use AI and other advanced technologies in next-generation entertainment products.

Separately, we believe that Netmable will leverage its gamer database to acquire new users, retain loyal gamers, sell lucrative in-game items, and effectively control operating costs. And we expect Nexon to use AI and related systems to improve the gamer experience as well as operating efficiency for specific game genres and various business procedures. By solving underlying problems through the use of AI, we think the industry leaders stand to benefit from their AI initiatives from 2018.

Pan-Asia Internet and Online-game Sector: PER bands of leading game companies NCsoft Netmarble Nexon

(KRW) 54.5X (KRW) 49.3x (JPY) 44.1X33.7X 43.5x 37.7x 600,000 200,000 1,800 23.3X 180,000 1,500 450,000 31.8x 27.4X

160,000 1,200 300,000 21.7X 140,000 900 16.1X 10.4X 150,000 12.8X 120,000 26.0x 600 4.7X 0 100,000

300

Jul-15

Jul-17 Jul-18

Apr-14 Oct-16

Oct-17 Apr-18

Jan-13 Jun-13 Jan-18 Jun-18

Jun-17 Jan-18 Jun-18

Mar-17

Feb-15

Mar-18 Feb-18

Nov-13 Sep-14 Dec-15 Aug-17

Dec-17 Aug-17 Sep-17 Nov-17

May-16

May-18

Jul-12 Jul-17 Jul-18 Jul-13 Jul-14 Jul-15 Jul-16

Jan-14 Jan-15 Jan-16 Jan-13 Jan-17 Jan-18 Jan-12 Source: Companies, Dataguide, Bloomberg

Pan-Asia Internet and Online Games: 11 July 2018

Global game sector: valuation comparison (10 July 2018) Company Ticker Rating Mkt cap PER (X) EV/EBITDA (X) Rev. growth (%) EPS growth (YoY) ROAE (%) OPM (%) (USDbn) 1FY 2FY 1FY 2FY 1FY 2FY 1FY 2FY 1FY 2FY 1FY 2FY Netmarble Games* 251270 KS Buy (1) 12.4 28.5 22.3 16.4 12.4 20.4 16.6 39.5 27.8 10.7 12.2 21.8 24.3 NCsoft* 036570 KS Buy (1) 7.6 16.6 11.9 8.7 6.1 12.1 18.6 15.8 39.1 17.1 19.9 36.7 41.2 Com2uS* 078340 KS O/P (2) 2.0 12.4 10.5 6.2 4.6 16.0 14.8 29.5 17.8 21.9 21.2 38.8 39.9 Kakao* 035720 KS Buy (1) 8.0 41.5 35.5 19.9 15.3 24.4 13.9 59.7 16.8 4.2 5.0 11.4 13.5 Pearl Abyss 263750 KS Not rated 2.5 13.6 9.2 9.8 5.5 N.A. 44.8 191.5 47.5 50.8 46.7 51.8 54.7 Korea average 22.5 17.9 12.2 8.8 18.2 21.7 67.2 29.8 20.9 21.0 32.1 34.7 Nexon* 3659 JP Buy (1) 13.4 14.3 13.7 8.5 6.9 18.5 7.7 80.0 4.7 19.3 17.0 42.8 44.2 Konami Holdings 9766 JP Buy (1) 7.0 20.1 18.9 9.2 8.4 9.7 3.6 20.0 6.6 14.1 13.5 21.0 21.7 Colopl 3668 JP Hold (3) 0.9 13.5 17.9 4.0 4.8 0.5 (7.4) (19.3) (24.6) 10.4 9.0 20.0 16.9 Square Enix 9684 JP O/P (2) 5.6 22.1 17.6 9.5 7.4 9.2 8.0 7.2 25.6 13.3 15.6 14.9 17.3 Mixi 2121 JP Hold (3) 2.0 6.7 7.4 1.2 1.3 (7.6) (9.2) (22.2) (9.5) 16.6 13.6 27.9 27.3 Cyberagent 4751 JP Buy (1) 7.2 105.8 58.8 17.5 14.5 13.1 11.5 87.5 80.1 9.5 15.3 8.2 9.0 Japan average 30.4 22.4 8.3 7.2 7.2 2.4 25.5 13.8 13.9 14.0 22.5 22.8 Electronic Arts EA US Not rated 44.3 29.0 25.8 18.7 16.2 8.3 6.7 13.2 12.5 28.5 26.5 33.9 35.7 Activision Blizzard ATVI US Not rated 58.5 29.6 25.8 20.2 16.9 4.8 7.9 13.8 14.6 19.6 18.8 34.6 37.0 US average 29.3 25.8 19.4 16.6 6.6 7.3 13.5 13.5 24.1 22.6 34.2 36.3 Tencent Holdings* 700 HK Buy (1) 468.4 34.0 25.8 26.4 20.8 51.8 40.0 37.7 32.8 28.6 26.7 21.8 17.9 NetEase* NTES US Buy (1) 35.1 22.0 17.7 14.5 11.2 32.1 25.1 (17.0) 24.9 20.9 21.8 17.0 17.0 China average 28.0 21.7 20.5 16.0 42.0 32.5 10.4 28.8 24.7 24.2 19.4 17.5 Global average 27.3 21.3 12.7 10.2 15.2 13.5 35.8 21.1 19.0 18.8 26.9 27.8 Source: *Daiwa forecasts, Bloomberg

Pan-Asia Internet and Online Games: 11 July 2018

AI adoption: a solution for innovation

Game industry is well poised to adopt AI technology We now see a singularity We believe the third AI boom began in 2010, driven by 2 major factors: 1) machine- in AI technology learning technology using Big Data from different devices, users, and applications, and 2) solid progress in deep learning algorithms. We believe the more successful use cases of AI systems have attracted many talented software engineers, more R&D investment, and stronger interest from end-consumers. We expect the current AI wave to continue to propel the evolution of all industries from 2018 onward.

The 3 ups and 2 downs of the AI industry (1960~)

Source: AI and Deep Learning, Yutaka Matso (2015)

Today’s AI is the fruit of Since being introduced in the 1960s, artificial neural networks (ANN) have faced difficulties research on artificial due to underlying theoretical and practical issues, such as over-fitting neural networks (ANN) (Oxforddictionaries.com: the production of an analysis that corresponds too closely or spanning several exactly to a particular set of data, and may therefore fail to fit additional data or predict decades future observations reliably), slow learning time, input variable selection, and a lack of use cases commercially. There were also other limitations, such as computing power and small data sets for training and testing. However, we have seen marked improvements in stochastic modelling, inference, and software algorithms over the past 30 years.

A deep learning Many academic and industry researchers have been working on ANNs to overcome these algorithm was a underlying limitations by inventing back propagation, supportive vector machines, drop- breakthrough in ANN outs, and advanced ANNs such as a recurrent neural network and convolutional neural network. In 2012, Geoffrey Hinton and his research team surprised the world with better- than-expected performance in an image recognition contest, based on deep neural network (DNN) and advanced inference algorithms. Google and others have since successfully adopted AI and deep learning technologies in order to solve various recognition problems.

Pan-Asia Internet and Online Games: 11 July 2018

Schematic representation of DNN architecture

Source: www.medium.com, Daiwa

AlphaGo, reinforcement AlphaGo is a computer program developed by Google’s DeepMind that plays the complex learning, and challenges board game Go. In October 2015, AlphaGo became the first computer Go program to beat a human player. In 2017, DeepMind introduced an advanced version, AlphaGo Zero, featuring more powerful gameplay, and trained the game to play against itself, starting from completely random plays. We note that DeepMind kicked off a new AI project (SC2LE: Starcraft II Learning Environment) with Activision Blizzard in 2017 to solve various in-game problems (observations, actions, and reward specifications) for Starcraft II, while working on deep reinforcement learning algorithms and architecture.

AlphaGo: neural network training pipeline and architecture

Source: DeepMind Note: SL – supervised learning, RL – reinforcement learning

AI is an opportunity for In our view, DeepMind’s efforts to use AI technology for online games underline the the game industry potential of AI for game companies seeking to improve the gamer experience and efficiency of game operations. Beyond the Go game, DeepMind also provides game developers with an opportunity to apply advanced AI technology to challenging problems within in-game play and the gaming environment, based on imperfect information, interactions with multiple players and delayed credit assignment (which are game system delays in giving rewards [items, points, credits] to users, even after a gamer wins a game or specific session).

Pan-Asia Internet and Online Games: 11 July 2018

Korea: key drivers for the evolution and revolution of AI technology

Source: NCsoft, Daiwa

Five questions for the game industry relating to AI There are 5 questions to consider when assessing the potential impact of AI on industry growth and game companies’ business models.

1) Why now? Over the past few decades, we have seen noticeable improvements in a game’s core components (graphics, sound, and computation power), leading to increased demand for AI algorithms to support a better game experience and more compelling features through human-like non-playing characters (NPCs) and dynamic gameplay. In the past, game developers emphasised improvements in graphics and characters’ motion to differentiate their game from rivals’. Recently, however, we have seen more AI-based NPCs acting intelligently and behaving like human players.

As gaming devices themselves become more powerful, game developers can incorporate AI to create more intelligent NPCs in titles featuring cutting-edge game engines. The primary purpose of AI technology is to increase an NPC’s ability to adapt to a new gaming environment, leading to better interactions with human gamers. In addition to faster networks and the growing computing power of PCs and smart devices, online gaming multi-play is increasing the demand for AI-supported game characters and gameplay.

Pan-Asia Games Sector: the past and present of gaming infrastructure 2000 2010 2018~ Hardware/ Display HD (High Definition) UHD (Ultra High Definition) VR Headset display* (resolution / pixels / format) 1,366x768 / 1,049,088 / 720p 3,840x2,160 / 8,294,440 / 2,160p 4,800x3,840 / 18,432,000 / 120Hz CPU Intel Pentium series (G5500) Intel i series (i7) Intel i series (i7) (cache / cores / threads) 4MB / 2 / 4 6MB / 4 / 8 12MB smart cache / 6 / 12 GPU GeForce 2~9 (9800 GTX) GeForce 200~900 (GTX 980) GeForce 10 (GTX 1080) (frame buffer) 512MB GDDR3 4GB GDDR5 8GB GDDR5X (memory speed) 2.2 Gbps 7 Gbps 10 Gbps CUDA cores (NVIDIA) 128 2,048 2,560

Game engines Unity 1 and 2 Unity 3 and 4 Unity 2018.1 • Apt for low-spec games • Mobile, console platform support • Scriptable render pipeline Unity • Supports PC platform only • Real-time shadows • HD render pipeline • Easier UI vs other engines • DirectX 11 rendering • Lightweight render pipeline Unreal 1 and 2 Unreal 3 Unreal 4 • Collision detecting • Gamma-correct HDR rendering • New lighting algorithm Unreal • Coloured lighting • Per-pixel lighting calculation • Reduced iteration time • Matinee cinematic editing tool • Mobile support from 2010 • Blueprint visual scripting system

Network WCDMA / 3G 4G / LTE 5G / IMT-2020 Data transfer / Latency 2 Mbps / 30ms 1 Gbps / 10ms 20 Gbps / 1ms

Source: Daiwa Note: VR headset display’s 120Hz represents the refresh rate, HDR: high dynamic range

Pan-Asia Internet and Online Games: 11 July 2018

2) What for? The game industry is evolving by offering more realistic and engaging gaming environments backed by AI-based content. AI has played a key role in powering intelligent game agents, based on complex algorithms that draw on interactive gamer data, NPCs, and in-game surroundings.

Historically, the game industry has used AI technology to produce NPCs, which are programmed characters within a game. The key roles for an NPC include automatically delivering game information to players, recognising user patterns, and offering gameplay assistance or guiding players. In addition, an NPC can play with a user at different levels of difficulty after analysing a gamer’s skill level.

AI helps an NPC behave like an intelligent character and allows NPC teammates or opponents to behave in a more human-like manner. In the role-playing game (RPG) segment, game developers already use AI technology to design NPCs smart enough to help gamers play together, find short cuts on in-game maps, and explore other in-game content to level up.

AI supports a variety of game applications

Source: NCsoft, Daiwa

In our view, online game companies should offer intelligent NPCs which can provide MMORPG users with a changing environment and new game episodes on a real-time basis. In the past, gamers focused on reducing their playing time after finding a winning strategy to use against NPCs when playing a game. Recently, we found that gamers prefer smarter NPCs, which make a game more exciting, immersive and dynamic, and games with this feature seem to enjoy effective retention of online gamers and relatively long life cycles.

3) Which games work Since the late 1990s, casual puzzle and board games (Go and chess) have used simple AI with AI? technology to offer more intelligent and human-like gameplay. With the rapid improvements in game-development engines and gaming peripherals (graphics cards, sound chips, and processors), we have seen a wider adoption of AI in commercial game software for consoles, online PC and smart devices.

In our view, today’s AI works best within a closed-game system with limited player actions and fewer players, and in less complex games where there are relatively few variables. As demonstrated by AlphaGo in the Go game, an AI-based game can perform well when directly interacting with human players. AI can also improve RPG titles, as this genre can offer an enhanced gamer experience resulting from Big Data analysis on game users and game traffic.

We note that game companies have adopted AI technology to offer various game features, including different battle modes, interfaces and virtual environments. Some of the most popular AI-based games during 2000-1H18 were The Sims (artificial life simulation), Freestyle, FIFA Online, and NBA (group intelligence), Unreal Tournament (flocking, where NPCs operate together rather than individually), and Age of Empires (path finding). Among the developers, NCsoft (PvE), Activision Blizzard (blocking of abusive chat), and Nexon (procedural content generation [PCG]) have been at the forefront of AI developments for games.

Pan-Asia Internet and Online Games: 11 July 2018

Global games: game titles featuring AI technology Game titles Developers Key features Overwatch Blizzard Detecting and penalising abusive language or unfair gameplay FIFA Online 4 Nexon AI controlled NPCs support game players as teammates Blade & Soul NCsoft AI controlled NPCs for Infinite Tower Durango Nexon In-game environment changes according to player’s location Aion NCsoft PVP matching based on players’ play history Sims Electronic Arts AI controlled NPCs Age of Empire Microsoft Enhanced path finding

Source: Daiwa

In our view, the game companies now adopting AI seek to do 2 things: 1) embed their games with more emotional and social agents, and 2) focus on problem-solving for various business divisions (say, development and operations) in the near future. One niche genre for AI use is the emotional games genre (eg, Ico by Sony and Prius Online) and social networking games, where a gamer uses emotion-based interaction with a virtual game character to move on to the next stage of the game and consume game content.

Rather than just simple competition vs. an NPC, we expect this kind of cooperation with NPCs to make a gamer more actively engage with a virtual world, leading to more spending on in-game items and more time being spent within the ecosystem. By harnessing AI algorithms such as adaptive and reinforcement learning, game companies are keen to shake up their virtual worlds and offer unexpected challenges to gamers. If the gamer believes that AI-supported content is new game content, they are likely to remain on the game platform, which should herald increased revenue for game developers.

4) What key AI We note that game companies have capitalised on the benefits of AI in many different technology has been ways. The primary reason for adopting AI is to improve the underlying features of a game deployed in games? over time.

 Better gaming experience: AI can amplify the entertainment features of various games. Besides in-game community activity, we think AI is critical to gameplay as it paves the way for more realistic battles, dynamic action, and unexpected NPC strategies to keep players on their toes. As NPCs have become more important to immersive gameplay, game developers have used AI to make NPCs more intelligent.

 More active gameplay: As game-development engines continue to improve through the use of advanced physics and rendering functions, online games have become more interactive in terms of the number of NPCs and the in-game environment. Game developers are actively incorporating AI to offer unique gaming experience powered by enhanced deep learning algorithms.

 Integration with state-of-the art technology: We expect to see closer integration between AI and gaming devices, data analytics, and other components. In our view, this tighter integration will lead to a better gamer experience. Another trend is the use of AI in data mining for monetisation, effective marketing promotion, and customer service. Companies are using their well-structured and established game user databases to pinpoint which stages of a game are deemed by gamers to be the “most fun”, and develop new business models based on such findings.

AI technology: key game features Features Description Adopted games Path finding Game characters choose the best, fastest, and shortest path Age of Empire Group behaviour AI controls multiple NPC movements strategically FIFA Online 4 Customised difficulty Game difficulty customised accordingly to players’ skill level Blade & Soul Interactive environment In-game environment and NPCs interact according to players’ location Durango PVP matching PVP matching done based on players’ game record and performance Aion AI controlled NPCs NPCs behave differently according to their unique experience Sims

Source: Daiwa

Pan-Asia Internet and Online Games: 11 July 2018

We believe an AI system should understand a gamer, model how a user plays, and mimic how a human acts, and even make mistakes and behave unpredictably. In our view, higher-level AI systems should incorporate human habits or characteristics, in addition to logical and reasonable thinking.

5) Where is the game Over the past decade, we have seen AI being used in creative game design with the goal industry headed with AI? of attracting gamers’ interest. Going forward, we expect the game industry’s rapid adoption of AI technology to lead to more appealing game content that encourages gamers to join a game ecosystem.

Historically, AI in games has evolved in the following ways: 1) to defeat human gamers in competitive gaming environments, and 2) to enhance game quality by mimicking real objects or user gameplay. AI is now being used in the RPG genre to improve NPC responses and strategies, while NPCs and monsters are rapidly evolving into smarter objects through the use of AI.

In our view, the best use of AI in the game industry is to minimise the gap between AI- assisted NPCs and real gamers in terms of gameplay. To this end, the use of behavioural cloning technology makes users interacting with AI-powered characters feel as if they are playing with real human competitors. For example, in online soccer games, AI technology is being used to support more dynamic gameplay and improved strategies. Nexon’s FIFA Online 4 has proven popular among gamers due to its improved physics engine, which is based upon AI technology.

Compared with console games, online and mobile games have limited resources to incorporate AI due to their focus on graphics and user interfaces. However, we are seeing more mobile games dedicate available resources to include an AI module that supports more dynamic gameplay via intelligent NPCs. For example, Nexon’s Durango game features procedural content generation, which generates new game content (NPCs, quests and maps) dynamically, depending on a gamer’s strategy and responses, and results in a different gaming experience and conclusion each time.

We believe game companies should use AI in different genres and spend more money and time to develop in-house game engines, which can improve production efficiency by shortening the game-development period (ie, game design and new feature simulation) and eventually overall game quality. In the future, we expect game developers to use multiple AI technologies to maximise game quality and allow for more complex and challenging gameplay between users and NPCs.

Pan-Asia Internet and Online Games: 11 July 2018

Korea: the AI wave is coming

Driving the new paradigm in a more intelligent way Bringing gaming to life In our view, the game sector is better positioned than other sectors, ie manufacturing, e- through AI and deep commerce, and online advertising, to capitalise on AI technology because it has access to learning highly relevant datasets revolving around game development, marketing, and in-game item sales. We believe game companies can effectively design and develop AI systems by using Big Data analytics on their well-structured and long-running databases of paying gamers, in-game item transactions and gamer reviews.

Data is the most critical asset for any company to form a winning AI strategy, in our view. In particular, we think the diversity and scale of databases are important factors in AI system development. According to AI industry experts, management should support AI R&D to drive project innovation and communicate with all staff to identify problems in the core business process.

Korea’s leading game More importantly, we believe game companies face less business risk when initiating new companies have data AI services compared with other industries, because they can build a strong dataset from assets that can be used their game services without the need for additional devices and investment. Hence, we in AI believe that game companies with proven expertise in building quality databases are in a position to lead AI development in Korea and globally.

Korea game industry: big and valuable data assets for AI system

8.5% Industry growth 15~19(E) 908 5.7% 10,655 CAGR Number of KRW4.3tn Global Number of game Total market PC café developer, revenue share distributor

78.4 min Korea (97.7 min in KRW4.6tn Game weekends) Total Online Mobile Average revenue industry daily play (2016) time

KRW19,078 KRW27,766 KRW10.9tn Average Average USD3.3bn Total monthly in- monthly Export revenue game spending 73,993 purchase Industry worker

Source: White paper on Korean games 2017, KOCCA, Daiwa

From small companies By using advanced AI technologies, we believe game companies are likely to incorporate to Big Data platforms more immersive and advanced game features into their games to boost revenue and create new businesses over the long term. For example, Netmarble has developed an AI- based game system which monitors user gameplay and helps gamers find ways to survive in a tough gaming environment. Meanwhile, Nexon’s FIFA Online 4 features super-realistic soccer player movements based on a new game engine and AI technology.

In our view, game companies should start with small AI systems, and then continue to develop and evolve the systems by integrating new game content and using it to support the live operations of existing games. In Korea, we also expect game companies to focus on weak AI or soft AI, which uses AI to support well-established revenue models, rather than non-core and new businesses, given intensifying competition from newcomers and a falling ratio of hit new games. We think this strategy will provide greater higher visibility on AI investment and quicker monetisation, as the focus is on existing business offerings and available assets.

Pan-Asia Internet and Online Games: 11 July 2018

Industry data sets: the best quality for AI systems What about Korea? The Korean game industry has been a front-runner in designing online games, especially RPGs, monetising gamers with free-to-play services, and operating game services globally. However, the Korean game companies have been late in incorporating AI technology into their game businesses due to the following factors:

 High game-genre dependency on RPGs. Korea’s gamer base is relatively focused on RPGs, shooting games, and sports games, mainly on online and mobile devices. Due to this game concentration and the limited number of PC platform games, we believe domestic game companies were not motivated to use AI technologies (eg, the view was that the RPG genre required less AI to run the game, as the game players effectively built their own worlds). In our view, the domestic game companies view player-versus- player (PvP) mode as a key game feature, along with in-game modes for competition (eg, ranking system) or cooperation (eg, party system).

Korean game industry: high dependency on the RPG genre (%) RPG 82 65.8 Action 27 22.1 Web/Board 8 9.1 Shooting 8 10.9 Sports 9 13.4 Simulation 11 9.3 Adventure 9 10.2 Puzzle 6 9.9 Fighting 8 9.9 Educational 2 5.8 FPS/TPS 13 4.3 AOS 10 5.1 Other 19 17.5 Online Mobile

Source: White paper on Korean games 2017, KOCCA, Daiwa Note: game companies’ most produced / distributed genre of game (aggregate of 1st, 2nd, 3rd choices)

 Lack of key developers for niche genres. Korea historically focused on popular game genres or simple gameplay, due to: 1) uncertainties related to the hit ratio of new games in niche segments (sports and strategic simulation), 2) weak R&D capability to develop AI algorithms, and 3) the relatively small console and packaged-game market in Korea. However, the FIFA Online series by Electronic Arts has proven successful because of its AI-based game tactics and dynamic team play environment.

 Limited service expansion to Pan-Asia region. Pan-Asia countries were historically the primary target markets for Korean game companies, and demand in these markets for AI-assisted gameplay in niche genres and casual games had been relatively weak. To benefit from the growing scale of game operations, the domestic game developers have been prioritising quick commercial launches into addressable game markets in Asia.

Korea game industry: game revenue by geographical region

Other 7% Europe 10% China 38% North America 11%

Southeast Asia 16%

Japan 18%

Source: White paper on Korean games 2017, KOCCA, Daiwa

Pan-Asia Internet and Online Games: 11 July 2018

 Few internal game-development engines. Korean game companies have tended to use two game-development engines (Unreal and Unity) developed by international companies, in order to save development costs and shorten development times. Korean game developers have also been conservative in developing in-house AI game engines and key AI algorithms, while looking to capture new business opportunities with new games and new game sequels.

Since 2017, however, we have seen the Korean online-game companies aggressively adopt AI technology in order to penetrate global markets, where various competitors have differentiated their games through the inclusion of AI-based features and advanced rendering and physics engines. NCsoft, Netmarble, and Nexon have been investing in internal R&D centres for AI systems since 2016 to stand out from their peers in being able to offer more advanced gameplay.

AI spending will focus IDC forecasts that spending on cognitive and AI systems for Asia Pacific (ex-Japan) will on software and expand at a 69.8% CAGR over 2016-21 and total USD5.0bn in 2021 (from USD0.35bn in intelligent service agents 2016). The industry research firm expects adoption of cognitive and AI systems in the region to accelerate on the back of increasing demand for automated customer services, intelligent processing automation, expert shopping advisors and digital assistants. IDC expects that capex will be spent on software and systems, and then services and hardware technology.

Top use cases for cognitive AI systems globally (2016-21)

91.2%

88.4%

85.0%

82.2%

81.6%

66.4%

Expert shopping advisors and product recommendations Automated claims processing Intelligent processing automation Digital assistants for enterprise knowledge workers Merchandising for omni channel operations, supply and logistics Others Source: IDC (Mar 2018), Daiwa

Pan-Asia Internet and Online Games: 11 July 2018

Clash of the titans: race for market leadership

New competition likely to emerge AI technology: use The industry leaders in Korea’s game market have been looking for the technology benefits cases for the game associated with AI to improve game visuals, create a real-world environment inside a industry virtual space, offer more personalised gameplay, and utilise powerful game-design tools. We believe the companies have taken advantage of their game ecosystems to develop proprietary AI systems with reliable input datasets.

There have been a variety of use cases for AI technologies in global game markets, ie, game testing, in-game intelligence, graphics enhancement, voice recognition, and synthesis and VR enhancements. AI and deep learning improve games by making them smarter and more realistic, improving the overall gaming experience, and translating developers’ skills into online game services. Also, these technologies will help to make mobile games smarter, by helping developers to create more interactive and immersive content for smart devices.

Major differences and Given that game companies have different gamer assets and strategic focuses, we expect similarities in AI companies to pursue different AI strategies and target different markets. However, we strategies believe that all the companies should focus on improving the gamer experience in the short term, and develop advanced gameplay in the long term, by incorporating AI technologies into their game content and gaming infrastructure.

Korea vs. global game industry: key differences and similarities in AI adoption Differences Similarities

Target platform/genre PC online (Korea) vs. console Migration to mobile devices RPG (Korea) vs. sports, simulation and unique casual games Social and emotional games AI system Third-party engines (Korea) vs. embedded AI system and Game operation and user interface modules

Business model Gamer retention (Korea) vs. user experience Marketing and customer service with big data analysis New games (Korea) vs. core franchise titles Increasing traffic and duration

Source: Daiwa

Findings from our on- From our meetings with AI specialists in the game industry, we highlight the 3 key the-ground interviews implications for companies to consider when incorporating AI technology into their game with industry experts development procedure and commercial services.

 A different gaming experience. Industry experts believe game companies should offer a totally new and unique experience for gamers, who have been traditionally playing with human gamers via PvP mode, among in-game communities, in a highly competitive gaming environment. In-game AI systems can help gamers to navigate an uncharted virtual world and complete tough missions to increase gamer loyalty and gameplay duration.

 Beyond intelligence. The specialists we met suggest that NPCs should evolve as partners in gameplay, rather than as enemies or competitors, to improve interaction and communication with gamers. Through increasing interaction for both gameplay and in- game activities, the AI system can help users play better, stay longer, and feel more comfortable within the game platform, leading to increased spending on game content.

 AI with new gaming devices and technologies. AI-embedded games may face limitations stemming from hardware, ie, displays and sensors. Experts we spoke to believe AI technology could improve the gamer experience by using advanced gaming devices equipped with virtual reality (VR), augmented reality (AR), and various sensing technologies.

The industry experts we spoke to expect a mixed reality (software AI) and hardware (AR, VR, and sensors) to emerge as a disruptive technology, resulting in immersive gameplay and blurring the lines between real life and the virtual world.

Pan-Asia Internet and Online Games: 11 July 2018

AI: enhancing earnings power in the long term

AI is not everything, but could be an engine for earnings growth AI as the foundation for Although there are few proven business models to successfully use AI technology among digital transformation the Korean game companies to date, we think the rapid adoption of AI technology will boost operating metrics, increase revenue, and lower costs from 2019, leading to strong operating leverage for the companies under our coverage.

Game companies can increase monetisation by offering more exciting gameplay, increasing gameplay time, and promoting the use of in-game items for tough battle modes. We believe more personalised services under an AI system could support game operations and marketing promotions in a more efficient manner, and drive strong in-game item sales.

NCsoft has tapped the AI In January 2016, NCsoft unveiled its first game with AI content: the Tower of Infinity opportunity through its expansion pack for its Blade & Soul (B&S) game. NCsoft applied AI technology to present B&S game a more appealing player versus environment (PvE) mode, with intelligent NPCs, based on reinforcement learning and the same skillset as human gamers. Also, it has been using AI- assisted matching technologies for Aion since 2012, offering PvP content after matching a player with a counterpart gamer based on skill level and in-game progress, or an NPC after evaluating their gameplay history.

NCsoft: yearly revenue of B&S and Aion (KRWbn, 2012-18E) 120 20%

100 10% 0% 80 (10%) 60 (20%) 40 (30%)

20 (40%)

0 (50%) 2012 2013 2014 2015 2016 2017 2018E Aion B&S Aion YoY (RHS) B&S YoY (RHS)

Source: Daiwa forecast

Revenue for NCsoft’s B&S and Aion saw CAGRs of 7% and -14%, respectively, over 2015- 17. Aion’s revenue declined due to online gamers’ migration to B&S and other competitors’ mobile games. We believe the company has benefited in terms of extending the life cycles of both games by using AI. Voice-recognition technology has also helped NCsoft’s gamers communicate with other gamers, which we believe has led to gamers spending more time on a game, as well as more money on in-game item purchases.

Business benefits to Deep learning technology can also help game companies save substantial operating costs emerge from all fronts and reduce time and errors in new game development by determining which variables in the development process are the most important. In particular, a game company can support its game-development team by using AI for simple tasks such as applying graphics to a sketch and translation, freeing programmers to focus on higher-level tasks such as gameplay design.

NCsoft, Netmarble, and Nexon have seen increases in their marketing and labour costs (including R&D) by CAGRs of 63% and 21% over 2010-17, driven by a rise in labour costs, new game-development projects, and SG&A costs for game operations in Korea and globally. At the same time, we believe these companies have ramped up their software engineers headcount relating to new technologies (AI, deep learning, and various facial and voice recognition technologies).

Pan-Asia Internet and Online Games: 11 July 2018

Korea: SG&A cost trend by major game developers (KRWbn, 2010-17) 1,600 14,000

1,400 12,000 1,200 10,000 1,000 8,000 800 6,000 600 4,000 400 200 2,000 0 0 2010 2011 2012 2013 2014 2015 2016 2017 Labor Marketing Number of personnels (RHS)

Source: Companies, Daiwa Note: all figures are based on the aggregation of Nexon, NCsoft, and Netmarble

We expect the abovementioned companies to add more AI software engineers to develop and upgrade their gaming platforms, gameplay design and gaming environment. In 2018- 20, we believe a rise in R&D costs and labour expenses could weigh on profitability. However, we expect the game companies to continue to focus on cutting costs through the use of AI technology, in the areas of R&D, marketing, and in-gamer monetisation over the medium term.

Risks to our Positive sector view The game companies’ labour costs are likely to rise in 2018 as they hire more software developers to design and develop AI platforms. A bigger-than-expected rise in such costs is the primary risk to our sector view.

Increasing use of AI is There are also privacy issues surrounding user data, given that AI systems use personal likely to stoke privacy data gathered from live service offerings. In our view, a potential change in regulations concerns could prevent companies from actively capitalising on the use of Big Data. AI systems needs to draw on Big Data comprised of user, transaction, and payment information. There is a risk of such data being hacked, given the increasing usage of cloud services and third- party data centres, which would potentially damage brand equity.

Pan-Asia Internet and Online Games: 11 July 2018

Korea Information Technology 11 July 2018

NCsoft (036570 KS) NCsoft

Target price: KRW515,000 (from KRW470,000) Share price (10 Jul): KRW386,500 | Up/downside: +33.2%

A smart approach to the next wave of intelligent games

 Looks well placed to ride the AI wave in the global game industry Thomas Y. Kwon (82) 2 787 9181  New blockbusters should boost earnings on improving cost structure [email protected]  Reiterating Buy (1) rating; raising 12-month TP to KRW515,000

What's new: Following our recent meeting with the head of NCsoft’s AI Forecast revisions (%) centre, we are more positive on the company’s competitive advantage in Year to 31 Dec 18E 19E 20E developing next-generation games and its strong earnings prospects over Revenue change (3.2) (1.1) (0.5) 2018-20E. We expect NCsoft to harness AI systems to offer more Net profit change (8.5) 1.1 2.7 Core EPS (FD) change (8.5) 1.1 2.7 immersive and intelligent entertainment content in 2018-20E. Source: Daiwa forecasts

What's the impact: First-mover in adopting AI for games in Korea. We Share price performance believe NCsoft will move up the AI path by leveraging on its game-industry (KRW) (%) expertise, lengthy investment in AI-related projects, and ongoing efforts to 490,000 130 improve productivity and cost efficiency. It started incorporating AI-powered 447,500 118 non-playing characters (NPCs) in its flagship Blade & Soul (B&S) game in 405,000 105 2016, and we think it will expand this move into other applications 362,500 93 320,000 80 (advanced technologies for Big Data analysis, voice and video recognition). Jul-17 Oct-17 Jan-18 Apr-18 Jul-18

NCSoft (LHS) Relative to KOSPI (RHS) Racing for global leadership with popular IP-based games. We are confident of NCsoft’s ability to deliver quality games for mobile and PC 12-month range 332,500-488,000 online, even with the delayed launch (from 4Q18 to 2019) of mobile title Market cap (USDbn) 7.60 Blade & Soul 2 (B&S2). Management expects big new titles (Aion Tempest, 3m avg daily turnover (USDm) 43.35 Project TL) to lead to a multi-year business-growth cycle from 2019. We Shares outstanding (m) 22 Major shareholder National Pension Service (11.9%) forecast NCsoft’s revenue to see a CAGR of 11.8% for 2017-20E, driven by the addition of large-scale content updates, revenue from new games, and Financial summary (KRW) enhanced gamer experiences through the use of advanced AI systems. Year to 31 Dec 18E 19E 20E Revenue (bn) 1,971 2,337 2,460 Solid earnings momentum on improving cost structure. We look for Operating profit (bn) 723 963 1,028 Net profit (bn) 511 711 757 NCsoft to reengineer its business model and cost structure through the Core EPS (fully-diluted) 23,287 32,393 34,526 adoption of new technologies from 2H18. We forecast an operating-profit EPS change (%) 15.8 39.1 6.6 margin of 37-42% for 2018-20E, supported by rising royalties from Daiwa vs Cons. EPS (%) 6.7 6.4 1.7 PER (x) 16.6 11.9 11.2 franchise game IP (Lineage 2, B&S), strong overseas revenues, and cost Dividend yield (%) 2.3 2.5 3.1 benefits from the use of AI across divisions. We revise down our 2018E DPS 8,800 9,800 12,000 EPS by 8.5%, but lift the 2019-20E EPS by 1-3% in expectation of strong PBR (x) 2.6 2.2 2.0 EV/EBITDA (x) 8.7 6.1 5.3 royalties from overseas and IP-based mobile games, and cost savings. We ROE (%) 17.1 19.9 18.4 forecast EPS rises of 16% YoY for 2018 and 39% YoY for 2019. Source: FactSet, Daiwa forecasts

What we recommend: We lift our 12-month TP to KRW515,000 (from KRW470,000), based on the average of the 2018-19E EPS (from 2018E) and an unchanged target PER of 18.5x, the global peer average (Daiwa, Bloomberg forecasts). We reaffirm our Buy (1) rating, as we expect strong monetisation of new games in 2018-20. Key risk: slower-than-expected launch of blockbuster games.

How we differ: Our 2018-20E EPS are 1.7-6.7% above the consensus, likely due to our view of strong operating leverage for its core online games and new blockbuster mobile titles.

See important disclosures, including any required research certifications, beginning on page 60

NCsoft (036570 KS): 11 July 2018

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook NCsoft: revenue mix and profitability outlook (KRWbn, 2010-20E) We forecast NCsoft’s revenue to expand by 12.1% YoY in 2,500 45 2018 and 18.6% YoY in 2019, driven by large-scale content 40 updates for Lineage M and its core online games, and the 2,000 35 commercial launches of new mobile games like B&S2 and 30 1,500 Aion Tempest. In our view, the company’s strategic focus 25 20 on enhancing its IP value will start paying off from 2H18 as 1,000 new online games like Project TL, and potentially a sequel 15 to Guild Wars 2, enter commercial service. 500 10 5 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018E 2019E 2020E

Total revenues OPM (%, RHS) Source: Company, Daiwa forecast

Valuation NCsoft: share-price trend and operating profit NCsoft shares were rerated to a PER range of 20-22x for 350 500,000 2016-17, from 17x in 2014, following the successful launch 300 400,000 of LM and sustained revenue for all of its online games in 250 Korea. We believe that LM’s revenue is likely to stabilise 300,000 after falling from its July 2017 peak, and that the market 200 will come to appreciate the company’s IP assets, in-game 150 200,000 ecosystem, and game development capabilities, which 100 should support higher valuation multiples from 2019. 100,000 50

0 0 2013-12-01 2014-12-01 2015-12-01 2016-12-01 2017-12-01 Operating profit (KRWbn, LHS) Share price (KRW, RHS)

Source: Company, FNdata, Daiwa forecasts

Earnings revisions NCsoft: Daiwa’s EPS forecasts vs. Bloomberg consensus

The Bloomberg consensus estimates for NCsoft’s earnings (KRW) for 2018 have been revised down in recent months due to 36,000 the B&S2 launch postponement and a rise in labour costs 30,000 for new game development and incentive payments.

However, we anticipate upward revisions to the 2019-20 24,000 EPS consensus forecasts as the company starts to realise strong revenues from its new blockbuster titles in Korea 18,000 and globally. 12,000 Feb-15 Aug-15 Feb-16 Aug-16 Feb-17 Aug-17 Feb-18 Consensus 2018 Consensus 2019 Daiwa forecast 2018 Daiwa forecast 2019

Source: Bloomberg, Daiwa forecasts

NCsoft (036570 KS): 11 July 2018

Financial summary Key assumptions Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E PC café market share (%) 14.5 11.8 9.4 7.1 5.2 8.0 9.5 9.5 Royalty revenues to total revenues (%) 8.7 16.3 11.8 12.2 13.7 31.9 31.7 33.8 Mobile game to total revenues (%) 0.0 0.0 0.0 4.1 59.1 63.6 61.9 62.6

Profit and loss (KRWbn) Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Lineage I&II Revenues 345 323 376 453 220 191 189 191 Aion Revenues 96 94 74 72 47 52 52 52 Other Revenue 316 422 389 459 1,492 1,728 2,096 2,216 Total Revenue 757 839 838 984 1,759 1,971 2,337 2,460 Other income 0 0 0 0 0 0 0 0 COGS 0 0 0 0 0 0 0 0 SG&A (551) (561) (601) (655) (1,174) (1,247) (1,374) (1,431) Other op.expenses 0 0 0 0 0 0 0 0 Operating profit 205 278 237 329 585 723 963 1,028 Net-interest inc./(exp.) 16 17 20 19 16 27 41 41 Assoc/forex/extraord./others (6) (7) (18) (1) 9 (33) (6) (6) Pre-tax profit 216 289 240 346 610 717 998 1,063 Tax (58) (61) (73) (75) (166) (202) (281) (300) Min. int./pref. div./others 0 2 (1) 1 (3) (4) (6) (6) Net profit (reported) 159 230 165 272 441 511 711 757 Net profit (adjusted) 159 230 165 272 441 511 711 757 EPS (reported)(KRW) 7,247 10,490 7,542 12,417 20,104 23,287 32,393 34,526 EPS (adjusted)(KRW) 7,247 10,490 7,542 12,417 20,104 23,287 32,393 34,526 EPS (adjusted fully-diluted)(KRW) 7,247 10,490 7,542 12,417 20,104 23,287 32,393 34,526 DPS (KRW) 600 3,430 2,747 3,820 7,280 8,800 9,800 12,000 EBIT 205 278 237 329 585 723 963 1,028 EBITDA 241 315 272 360 614 759 999 1,047

Cash flow (KRWbn) Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Profit before tax 216 289 240 346 610 717 998 1,063 Depreciation and amortisation 35 37 34 31 29 36 36 18 Tax paid (24) (67) (2) (140) 108 (352) (281) (300) Change in working capital (6) (12) 13 (65) 48 18 18 7 Other operational CF items (241) 12 13 (56) 147 12 (1) (1) Cash flow from operations (20) 259 298 116 942 431 770 788 Capex (102) (19) (18) (17) (29) (22) (24) (25) Net (acquisitions)/disposals (109) (150) (503) (192) (1,257) (50) (27) (27) Other investing CF items 162 (12) (11) 7 (33) (4) (4) (4) Cash flow from investing (49) (181) (531) (202) (1,319) (76) (54) (57) Change in debt (15) (8) 0 149 0 0 7 8 Net share issues/(repurchases) 0 1 90 (144) 0 156 0 0 Dividends paid (12) (12) (68) (60) (81) (155) (187) (208) Other financing CF items 0 0 0 0 0 0 0 0 Cash flow from financing (27) (19) 21 (55) (81) 1 (180) (200) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash (96) 59 (212) (141) (458) 356 536 531 Free cash flow (121) 240 280 100 913 409 746 762 Source: FactSet, Daiwa forecasts

NCsoft (036570 KS): 11 July 2018

Financial summary continued … Balance sheet (KRWbn) As at 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Cash & short-term investment 678 898 953 984 1,544 1,971 2,507 3,038 Inventory 1 1 1 1 1 4 5 5 Accounts receivable 81 90 89 158 193 207 245 258 Other current assets 25 31 40 48 35 39 46 49 Total current assets 786 1,020 1,083 1,192 1,773 2,221 2,804 3,350 Fixed assets 248 241 234 225 229 222 217 231 Goodwill & intangibles 112 95 64 53 52 49 45 42 Other non-current assets 334 344 838 891 1,472 1,440 1,624 1,496 Total assets 1,480 1,699 2,219 2,361 3,527 3,932 4,690 5,119 Short-term debt 3 0 0 0 0 150 157 165 Accounts payable 8 8 11 7 2 4 4 5 Other current liabilities 241 237 326 278 454 385 450 472 Total current liabilities 252 245 338 284 456 539 612 642 Long-term debt 5 1 1 150 150 0 0 0 Other non-current liabilities 64 77 92 31 192 148 148 148 Total liabilities 321 323 430 465 797 687 759 789 Share capital 11 11 11 11 11 11 11 11 Reserves/R.E./others 1,130 1,350 1,759 1,875 2,710 3,226 3,911 4,309 Shareholders' equity 1,141 1,361 1,770 1,886 2,721 3,237 3,922 4,320 Minority interests 18 15 19 10 8 8 9 10 Total equity & liabilities 1,480 1,699 2,219 2,361 3,527 3,933 4,690 5,119 EV 7,805 7,568 7,511 7,584 7,059 6,633 6,107 5,588 Net debt/(cash) (669) (897) (952) (835) (1,394) (1,821) (2,350) (2,872) BVPS (KRW) 52,076 62,045 80,693 85,985 124,037 147,561 178,769 196,919

Key ratios (%) Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales (YoY) 0.4 10.8 (0.1) 17.3 78.8 12.1 18.6 5.2 EBITDA (YoY) 26.9 31.0 (13.8) 32.6 70.4 23.7 31.6 4.8 Operating profit (YoY) 35.7 35.5 (14.6) 38.5 77.9 23.7 33.1 6.8 Net profit (YoY) 1.9 44.9 (28.1) 64.6 61.9 15.9 39.1 6.6 Core EPS (fully-diluted) (YoY) 1.7 44.7 (28.1) 64.6 61.9 15.8 39.1 6.6 Gross-profit margin 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 EBITDA margin 31.8 37.6 32.4 36.6 34.9 38.5 42.7 42.6 Operating-profit margin 27.1 33.2 28.3 33.4 33.3 36.7 41.2 41.8 Net profit margin 21.0 27.4 19.7 27.7 25.1 25.9 30.4 30.8 ROAE 14.8 18.4 10.6 14.9 19.1 17.1 19.9 18.4 ROAA 11.4 14.5 8.4 11.9 15.0 13.7 16.5 15.4 ROCE 18.6 21.9 15.0 17.1 23.8 23.1 25.7 24.0 ROIC 31.0 45.2 25.1 27.2 35.5 37.6 46.0 48.6 Net debt to equity n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Effective tax rate 26.6 21.3 30.5 21.6 27.2 28.2 28.2 28.2 Accounts receivable (days) 38.1 37.2 38.9 45.9 36.5 37.0 35.3 37.3 Current ratio (x) 3.1 4.2 3.2 4.2 3.9 4.1 4.6 5.2 Net interest cover (x) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Net dividend payout 8.3 32.7 36.4 30.8 36.2 37.8 30.3 34.8 Free cash flow yield n.a. 2.8 3.3 1.2 10.8 4.8 8.8 9.0 Source: FactSet, Daiwa forecasts

Company profile

NCsoft is a leading on-line and mobile game developer in Korea with its flagship games, Lineage, Aion, and Blade & Soul, and Lineage M. It operates its business in domestic and overseas market including China, Japan, Taiwan, UK, and North America.

NCsoft (036570 KS): 11 July 2018

Investment conclusion

The best way to play an economic downturn Too solid an earnings We believe NCsoft’s core game businesses will remain solid in 2H18, and even 2019, outlook to ignore, in our when we expect a slowdown in the domestic economy and consumption. Given rising view digital-content spending by the younger generation, we believe the company’s quality games for mobile and PC online are well placed to monetise loyal gamers, backed by the continuing addition of new game episodes together with strong in-game item sales.

During a downturn, we contend that NCsoft’s solid revenues and earnings growth will help it stand out from its game developers such as Electronic Arts, as we see the company offering good visibility on paying gamers, revenue streams, and earnings. On our forecasts, NCsoft’s top line and operating profit will expand at CAGRs of 11.8% and 20.7% for 2017-20E, respectively.

Three reasons to buy In our view, the delay in the launch of B&S2 will give the company an opportunity to improve the overall quality of the game, in terms of episodes, graphics, and user interface. In view of the highly competitive environment in the mobile-game market in Korea and Asia, we believe NCsoft’s decision to push back the launch will prove to be prudent by the time 2019 comes around, as by then the game should be even better placed to stand out from its peers.

 Robust revenues from core games: We expect the company’s core franchise games on both platforms (smart devices and PC) to be resilient in terms of gamer traffic and revenue, supported by stable spending on in-game items by established in-game communities, compelling game content for game battles, and overseas expansion through the roll-out of well-plotted storylines. We forecast lucrative overseas royalties to see a CAGR of 51% and account for 32-34% of total revenue in 2018-20E.

 Big new IPs to debut from 1H19: Management aims to roll out blockbuster new games for mobile and PC in 2019, including B&S2, TL and Aion Tempest. Although there are still swing factors as far as the launch schedule is concerned, we believe these IP- backed new games will bring in new gamers, especially paying users, and add impetus to NCsoft’s earnings from 2019.

 Strong earnings generation: NCsoft believes its new game content for flagship games (Lineage M, Project TL, and B&S) will boost in-game item commerce from 2H18, triggered by gamers keen to “level up”. Besides, we expect the company to pursue a more disciplined strategy on operating costs and launch further cost-saving initiatives, including the use of AI systems and a scaling-back of marketing aimed at gamer acquisition and retention. We forecast NCsoft’s EPS to expand at a CAGR of 19.8% for 2017-20E, on strong operating leverage from new games and overseas revenue.

Proven game-IP assets likely to shine from 2H18 Valuation thoughts We raise our 12-month TP to KRW515,000 (from KRW470,000), based on our revised 2018-19E EPS average (from 2018E) and an unchanged target PER of 18.5x, the average of NCsoft’s global peers (based on Daiwa and Bloomberg forecasts). We reaffirm our Buy (1) rating, as we expect NCsoft to realise strong monetisation of new games for mobile and online platforms over 2018-20E.

We would view any share-price weakness resulting from investors’ concerns over delayed game launches as a further buying opportunity. Over the past 2 decades, we have seen NCsoft deliver quality new games consistently, even after delays of a few quarters in the commercial launches of some titles -- and we expect it to do the same with B&S2. Long term, we look for it to enhance its revenue streams and increase its earnings-generation capability, which should boost profitability and pave the way for higher cash dividend payments.

NCsoft (036570 KS): 11 July 2018

NCsoft: PER bands (KRW) 54.5X 44.1X 33.7X 600,000 23.3X

450,000

300,000 12.8X 150,000

0 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 Aug-17 Jan-18 Jun-18 Source: Company, DataGuide

NCsoft: EV/EBITDA bands

(KRW) 22.6X 19.2X 600,000 15.9X

450,000 12.5X

300,000 9.1X

150,000

0 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 Aug-17 Jan-18 Jun-18 Source: Company, DataGuide

NCsoft* 036570 KS Buy (1) 7.6 16.6 11.9 8.7 6.1 12.1 18.6 15.8 39.1 17.1 19.9 36.7 41.2 Netmarble Games* 251270 KS Buy (1) 12.4 28.5 22.3 16.4 12.4 20.4 16.6 39.5 27.8 10.7 12.2 21.8 24.3 Com2uS* 078340 KS O/P (2) 2.0 12.4 10.5 6.2 4.6 16.0 14.8 29.5 17.8 21.9 21.2 38.8 39.9 Kakao* 035720 KS Buy (1) 8.0 41.5 35.5 19.9 15.3 24.4 13.9 59.7 16.8 4.2 5.0 11.4 13.5 Pearl Abyss 263750 KS Not rated 2.5 13.6 9.2 9.8 5.5 N.A. 44.8 191.5 47.5 50.8 46.7 51.8 54.7 Korea average-ex NCsoft 24.0 19.4 13.1 9.5 20.3 22.5 80.0 27.5 21.9 21.3 31.0 33.1

Nexon* 3659 JP Buy (1) 13.4 14.3 13.7 8.5 6.9 18.5 7.7 80.0 4.7 19.3 17.0 42.8 44.2 Konami Holdings 9766 JP Buy (1) 7.0 20.1 18.9 9.2 8.4 9.7 3.6 20.0 6.6 14.1 13.5 21.0 21.7 Colopl 3668 JP Hold (3) 0.9 13.5 17.9 4.0 4.8 0.5 (7.4) (19.3) (24.6) 10.4 9.0 20.0 16.9 Square Enix 9684 JP O/P (2) 5.6 22.1 17.6 9.5 7.4 9.2 8.0 7.2 25.6 13.3 15.6 14.9 17.3 Mixi 2121 JP Hold (3) 2.0 6.7 7.4 1.2 1.3 (7.6) (9.2) (22.2) (9.5) 16.6 13.6 27.9 27.3 Cyberagent 4751 JP Buy (1) 7.2 105.8 58.8 17.5 14.5 13.1 11.5 87.5 80.1 9.5 15.3 8.2 9.0 Japan average 30.4 22.4 8.3 7.2 7.2 2.4 25.5 13.8 13.9 14.0 22.5 22.8

Electronic Arts EA US Not rated 44.3 29.0 25.8 18.7 16.2 8.3 6.7 13.2 12.5 28.5 26.5 33.9 35.7 Activision Blizzard ATVI US Not rated 58.5 29.6 25.8 20.2 16.9 4.8 7.9 13.8 14.6 19.6 18.8 34.6 37.0 US average 29.3 25.8 19.4 16.6 6.6 7.3 13.5 13.5 24.1 22.6 34.2 36.3

Tencent Holdings* 700 HK Buy (1) 468.4 34.0 25.8 26.4 20.8 51.8 40.0 37.7 32.8 28.6 26.7 21.8 17.9 NetEase* NTES US Buy (1) 35.1 22.0 17.7 14.5 11.2 32.1 25.1 (17.0) 24.9 20.9 21.8 17.0 17.0 China average 28.0 21.7 20.5 16.0 42.0 32.5 10.4 28.8 24.7 24.2 19.4 17.5

Global average-ex NCsoft 28.1 21.9 13.0 10.4 15.5 13.1 37.2 19.8 19.2 18.8 26.1 26.9

Source: *Daiwa forecasts, Bloomberg Note: For Nexon, we use fully diluted adjusted EPS for forecast years after factoring in the stock split carried out as at end1Q18

NCsoft (036570 KS): 11 July 2018

AI history and R&D capabilities

AI initiatives First-mover in AI R&D NCsoft set up its in-house team for AI research in 2011 and has steadily expanded the initiatives in Korea group in the years since then. Through the addition of new R&D projects and the development of state-of-the art technology, the AI division has continued to build up its technology database and software expertise.

NCsoft: a brief history of AI R&D centre Year Key incidents 2011 Established AI Task Force (TF) 2012 AI TF expanded to AI Lab 2015 Established Natural Language Processing (NLP) team under AI Lab 2016 AI Lab expanded to AI Centre NLP team expanded to NLP Lab

2017 NLP Lab expanded to NLP Centre 2018 NC PAIGE planned to be released (July 2018) 2018 PVP AI 2.0 to be released (August 2018)

Source: Company, Daiwa

We believe the company’s AI engineers have spent their time enhancing the company’s R&D capabilities rather than simply seeking the right AI applications for commercial services. The AI software engineers have limited access to games’ live operations, and as a result we think the company has focused its AI investment on underlying technologies that can support game-related services internally.

Who’s who Leveraging on extensive Lee Jay-June, Ph.D has headed NCsoft’s AI division since 2011. Dr Lee has experience in AI expertise for game a number of fields, including telecommunications (SK Telecom [SKT]) and image processing (Inzi Soft). One of the first AI researchers in Korea, Mr Lee has a background in theoretical and practical AI R&D. In 2004-11, he worked on the innovative 1mm at SKT, a project to personalise mobile services by using AI technology.

NCsoft: AI division leader Current title Head of AI centre, NCsoft Name Mr. Lee Jay-June Education Computer Science, Yonsei University Master of Computer Science, KAIST

Doctor of Computer Science, KAIST

Work experience Co-founder, Inzi Soft CI department, SK Telecom

Head of AI Centre, NCsoft

Source: Company

Dr Lee believes that Korean companies should focus more on fundamental research, such as deep learning algorithms, natural language processing (NLP), image and voice recognition, and virtual reality, rather than simple application and system integration.

In our recent discussion with Dr Lee, he argued that Korea’s leading game companies have the potential to lead the pack globally in AI, as they have accrued the skills needed to build valuable databases (of gamer profits, item purchases, customer services, and marketing feedback), produce the world’s best game content and understand the gaming domain, and can monetise users through their proprietary business models (free-to-play service).

Meanwhile, Chang Jung-sun, who heads the company’s NLP centre, is a specialist in NLP and information processing, and formerly worked for Daum Soft and on SKT’s 1mm project. Mr Chang has previously worked on the development of a search engine for an Internet portal, a chat agent (aka chatbot), and text mining. He believes data containing valuable information from logs, images, postings, and Q&As is a key component of AI platforms.

NCsoft (036570 KS): 11 July 2018

Learning to address AI opportunities Looking for applications NCsoft currently has 5 R&D laboratories operating under its 2 main AI centres: 1) AI Centre for AI technology -- Game AI Lab, Speech Lab, Vision TF, and 2) NLP Centre -- Language Lab and Knowledge Lab. Over time, the company has upgraded task force teams and project units into larger divisions after hiring talented engineers and finding the necessary R&D projects. Through closer interaction with the company’s internal working groups, the AI Centre has become a technology engine for NCsoft, where staff can find useful solutions for application into existing tasks and future work.

NCsoft: AI Centre organisation chart

Source: Company

 Game AI Lab: AI R&D for game development and game services (game playing, game design, and game art), based on reinforcement learning, deep learning, and simulation. The group developed the battle mode for the Infinite Tower dungeon portion of Blade & Soul.  Speech Lab: emotion recognition and text-to-speech synthesis for gameplay and game development.  Vision TF: image and video recognition and generation. The group works on a generative adversarial network (GAN) for producing video clips, images, and graphics.  Language Lab: handles all technologies relating to Q&A, dialogue, text summarisation, and episode generation.  Knowledge Lab: focuses on knowledge extraction and utilisation, based on game logs, text, and user chats.

NCsoft (036570 KS): 11 July 2018

AI, games, and business strategy

First use of AI in commercial games Powering in-game For the AI used in B&S, the company notes that open APIs based on Starcraft II (SC2LE) battles through deep by DeepMind and Activision Blizzard have proved useful, while Dota 2 by Open AI served learning as a reference for the AI system design. In the Infinite Tower portion of B&S, gamers come up against a programmed environment, including AI-embedded NPCs. NCsoft developed its player-versus-player (PvP) AI with the goal of applying the same skills as human gamers and choosing the best action in any given circumstance.

After launching version 1.0 of B&S AI in 2016, NCsoft’s Game AI Lab rolled out an upgraded version (2.0) for Infinite Tower content, where users combine different skillsets on a 3D battleground. This AI content was developed based on reinforcement learning algorithms and fully connected neural networks. Harnessing input variables (location and skill effects), the AI system is designed to produce outputs as strategic actions based upon the same skills used by human gamers after incorporating reinforcement learning algorithms.

NCsoft: schematic architecture of B&S AI (2.0)

Source: Company

B&S AI (2.0) comprises fully connected layers of character classes, integrated game states, and decisions by character class. After simulating and testing the battle mode, the AI system runs on a deep reinforcement learning algorithm designed to help gamers make better decisions without having to rely on substantial input data, given the increase in the acquisition of valuable data for gamers and gameplay. Separately, the company is aiming to develop more intelligent agents for all game-development procedures (designs, graphics, and animation) in the future.

NCsoft (036570 KS): 11 July 2018

NCsoft: screenshot of B&S AI (2.0: Infinite Tower)

Source: Company

Gamers’ feedback on B&S AI was mixed – they were generally negative on the different skills needed to defeat AI assisted-NPCs, but positive on the blend of content (both PvE and PvP), as well as the evolution of battle skills. The company hopes to improve the AI system by giving it the ability to play more like a human gamer, say, by reacting to certain in-game events emotionally rather than rationally.

AI strategy and business initiatives Longer-term path to AI In our recent interview with Dr Lee, the head of NCsoft’s AI Centre, we learned about the company’s longer-term AI strategy, where it intends to focus on core technologies to enhance the competitive advantage of its core game services and new game titles. Management views AI as a powerful technology with the potential to provide alternative solutions to the problems being faced by many of the company’s divisions.

In our view, NCsoft aims to use AI technology for existing and new games, in order to provide more immersive experiences, better interfaces, and ultimately more valuable game services. We expect the company to take further steps that underline its acumen in AI by supporting all working groups, ranging from game development to marketing and customer services.

AI benefits and business opportunity Focusing on games with By broadening its focus to include NLP, computer vision, text mining, and voice AI and related recognition, the company plans to improve its AI systems with the aim of enhancing entertainment content gamers’ experience and ultimately boosting monetisation of its franchise games. After spending time on finding problems and seeking solutions to these problems internally, the company will be more likely to quickly incorporate AI systems into its core services and new game content, in our view.

Indeed, we suspect that NCsoft’s management would like to apply the company’s AI and other advanced technologies to all industries, given its view that there are many critical issues that could be addressed by such technology. By extension, we believe that by working with its many business partners internally and externally, NCsoft could build a value chain and ecosystem for its core game business in the long term.

NCsoft (036570 KS): 11 July 2018

Earnings outlook

Positive business-growth momentum likely in 2019-20E Delay in big game We are now more positive on NCsoft’s business-growth prospects for 2019-20E, as we launch should improve expect the company to roll out the delayed B&S2 in Korea and global markets during this earnings visibility for period. We believe this popular IP-based game will support strong revenue growth for 2019-20E NCsoft from 2019. Given NCsoft’s expanding scale of game operations, in terms of both region and platform, we look for it to record secular revenue growth from 2019-20E, backed by compelling game content, growing in-game ecosystems, and the rollout of new mobile games.

NCsoft: revenue mix and profitability outlook (KRWbn, 2010-20E) 2,500 50

2,000 40

1,500 30

1,000 20

500 10

0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018E 2019E 2020E Lineage 1 Lineage 2 Aion B&S GW2 Wildstar Lineage M Royalties Others OPM (%, RHS) Source: Company Note: Others include mobile games in service and new games to be released in 2H18-19

MMORPGs: the primary According to the company’s guidance, NCsoft intends to launch 4 new games in Korea in drivers for 2018-20E 2H18-19. As monthly revenues for its core mobile game (LM) have been stabilising, we believe the company will continue to focus on developing quality MMORPGs, which have relatively long life cycles and are effective in attracting new gamers.

In terms of strategy, we expect the company to work on sustaining the revenue from LM in Korea, sharpening the focus of its overseas operations in terms of providing localised content and promoting the sale of in-game items, and ramping up new game launches for target markets including China and Japan.

NCsoft: launch schedule for new games (2H18-19E) Genre Developer details and description Korea Lineage 2M Mobile MMORPG Mobile version of Lineage 2, battle game with full 3D graphics Blade & Soul 2 Mobile MMORPG Mobile version of Blade and Soul, battle game Project TL (The Lineage) Online MMORPG Developing with Unreal Engine 4, sequel to Lineage 1 Aion Tempest Mobile MMORPG Prequel to Aion, large scale field battle with party play feature

Overseas Lineage M Mobile MMORPG Targets western market Aion Legions of War Mobile Collection Targets North America and Europe, Developed by co-work with Iron Tiger Studio, Battle RPG game

Source: Company, Daiwa forecasts Note: shaded area - games to be released in 2H18

Strong operating We forecast NCsoft’s revenue to stage a CAGR of 11.8% for 2017-20E, with mobile game leverage on stable SG&A revenue contributing 62-64% of total revenue over the same period. Meanwhile, we expect costs for 2018-20E NCsoft to see an increase in its labour costs and R&D expenses in response to the intensifying competition in the mobile-game segment globally in preparation for the next- generation entertainment platforms. However, we look for the company’s overall cost structure to stabilise over our forecast horizon, even as it adds software engineers to develop new games and new technologies.

NCsoft (036570 KS): 11 July 2018

We forecast NCsoft’s EPS to see a CAGR of 19.8% for 2017-20E, on solid growth in revenue from its franchise mobile games and a robust rise in overseas royalty revenues, along with a disciplined cost strategy for marketing and other SG&A costs.

2Q18 preview Weaker-than-expected For 2Q18, we expect NCsoft’s revenue to surge by 78.6% YoY from a low base in 2Q17. 2Q18E on soft demand However, we estimate a 2.8% QoQ contraction to KRW0.46tn on soft demand for its for LM flagship mobile game, Lineage M, in Korea and overseas, along with a lack of new launches. For the same period, we look for operating profit of KRW171.2bn (up 355.8% YoY) and an operating-profit margin of 37.1%. However, we expect NCsoft to regain its revenue and earnings-growth momentum from 2H18, driven by increasing in-game item transactions as the company adds appealing content to LM and other flagship online games in Korea.

NCsoft: quarterly earnings trend (3Q16-2Q18E) (KRWbn) 2Q18E

3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 Daiwa Consensus

Revenue 217.6 284.6 239.5 258.6 727.3 533.3 475.2 461.8 435.0 YoY growth (%) 11.2 20.1 (0.6) 7.5 234.3 87.4 98.4 78.6 68.2 QoQ growth (%) (9.5) 30.8 (15.9) 8.0 181.2 (26.7) (10.9) (2.8) (8.4) Operating profit 65.1 101.7 30.4 37.6 327.8 189.2 203.8 171.2 163.7 YoY growth (%) 28.7 35.8 (59.8) (56.4) 403.4 86.0 569.6 355.8 335.8 QoQ growth (%) (24.4) 56.2 (70.1) 23.4 772.6 (42.3) 7.7 (16.0) (19.7) OP margin (%) 29.9 35.7 12.7 14.5 45.1 35.5 42.9 37.1 37.6

Source: Company, Bloomberg, Daiwa forecast

For 2H18, we expect NCsoft to deliver solid earnings growth, supported by effective monetisation of the increased gamer traffic for Lineage M following the launch on 30 May 2018 of the Black Flame content update for this game, strong revenue for high-quality mobile MMORPGs in Korea and China, and operating leverage resulting from a rise in lucrative royalties from overseas, and cost control on marketing and promotional events.

Earnings-forecasts revisions Downward revision to We revise down the 2018E EPS by 8.5% to reflect a higher effective tax rate and the delay 2018E EPS on rising in the launch of B&S2, but we revise up the 2019-20E EPS by 1.1-2.7% to factor in labour costs revenue from new mobile games, service-region expansion, and operating leverage arising from the rapid deployment of AI across business divisions. Meanwhile, we look for NCsoft’s franchise games to generate stable, visible and lucrative game revenue through 2H18, and to increase its earnings visibility for 2019-20E, by meeting gamers’ heightened expectations for its popular IP-based games in Asia and globally.

NCsoft: earnings-forecast revisions (KRWbn) Previous New Revision (%) 2018E 2019E 2020E 2018E 2019E 2020E 2018E 2019E 2020E

Revenue 2,036 2,363 2,472 1,971 2,337 2,460 (3.2) (1.1) (0.5) Operating profit 783 949 998 723 963 1,028 (7.6) 1.4 3.0 Net profit 558 703 738 511 711 757 (8.5) 1.1 2.7 EPS 25,440 32,044 33,622 23,286 32,393 34,526 (8.5) 1.1 2.7

Source: Daiwa forecast

Risks Key investment The primary investment risk to our call on NCsoft is a slower-than-expected launch of concerns blockbuster new games for online and mobile platform. Other risks are a surge in labour costs as a result of an increase in the headcount, and aggressive investment in non-core businesses.

Korea Information Technology 11 July 2018

Netmarble Games (251270 KS) Netmarble Games

Target price: KRW188,000 (from KRW171,000) Share price (10 Jul): KRW163,000 | Up/downside: +15.3%

Navigating a new growth path with big mobile games

 New game launches likely to enhance revenue streams from 2H18E Thomas Y. Kwon (82) 2 787 9181  Positive momentum in AI adoption and business expansion globally [email protected]  Reaffirming Buy (1) rating; raising our TP to KRW188,000

What's new: Following our recent company visit, we note that Netmarble is Forecast revisions (%) ramping up new game launches for 2H18 and 2019, targeting Korea and Year to 12 Dec 18E 19E 20E global markets. We expect the company’s monetisation efforts to boost Revenue change (3.2) (0.9) (0.4) earnings in 2018-20E, helped by its rapid adoption of AI systems and the Net profit change (5.6) 6.9 6.8 Core EPS (FD) change (5.6) 6.9 6.8 expansion of business scope into new target markets. Source: Daiwa forecasts

What's the impact: major mobile game titles on the launch pad. Share price performance Netmarble aims to roll out around 18 new mobile games in 2H18, including (KRW) (%) B&SR and Seven Knights 2, based on its popular IP. Through improved 200,000 130 game content and advanced gameplay, we expect new mobile games to 180,000 118 drive solid top-line growth for Netmarble and help it regain earnings-growth 160,000 105 momentum from 2H18. We forecast Netmarble to increase revenue by 65% 140,000 93 120,000 80 HoH and 52% YoY to KRW1.8tn in 2H18. Jul-17 Oct-17 Jan-18 Apr-18 Jul-18

Netmarble (LHS) Relative to KOSPI (RHS) Increasing scale overseas. Following its successful launch of popular IP- based mobile games (Harry Potter: Hogwarts Mystery and Marvel: Future 12-month range 127,500-199,500 Fight) in the EU and US, we believe Netmarble will leverage its gamer base Market cap (USDbn) 12.42 overseas, in order to promote its new mobile games and other 3m avg daily turnover (USDm) 36.61 entertainment content from 2018. We forecast Netmarble to expand its Shares outstanding (m) 85 Major shareholder Bang, Jun hyuk (24.4%) overseas revenue by 11-41% YoY in 2018-20E, driven by service-region expansion into Asia and overseas. Financial summary (KRW) Year to 12 Dec 18E 19E 20E Improving earnings visibility on new launches We forecast Netmarble Revenue (bn) 2,919 3,404 3,567 to maintain an operating-profit margin of 21.8-24.6% in 2018-20E, Operating profit (bn) 637 828 876 Net profit (bn) 487 622 659 supported by solid revenue growth, stable SG&A costs, and operating Core EPS (fully-diluted) 5,724 7,318 7,750 leverage as a result of the adoption of AI tech in game development and EPS change (%) 39.5 27.8 5.9 operations. We forecast an EPS CAGR of 23.8% over 2017-20E. Daiwa vs Cons. EPS (%) 12.7 4.6 3.6 PER (x) 28.5 22.3 21.0 Dividend yield (%) 0.3 0.4 0.5 What we recommend: We lower 2018E EPS by 5.6% to factor in likely DPS 550 650 750 weaker-than-expected revenue from its core mobile games, but raise 2019- PBR (x) 2.9 2.6 2.3 EV/EBITDA (x) 16.4 12.4 11.3 20E EPS by 6.8-6.9% to reflect Netmarble’s expansion in Japan, the US ROE (%) 10.7 12.2 11.5 and the EU through new games. We reiterate our Buy (1) call and lift our Source: FactSet, Daiwa forecasts 12-month TP to KRW188,000 (from KRW171,000), on a new target PER of 28.8x (from 28.2x), a 22% premium to the average of its global peers (23.6x), on our revised 2018-19E EPS (from 2018E only). In our view, Netmarble’s continued launches of blockbuster mobile games argue for a valuation premium. Key risks: delays in game launches globally, as well as a rise in labour costs for new game development.

How we differ: Our 2018-20E EPS is 3.6-12.7% above consensus as we expect Netmarble to see strong operating leverage from lucrative overseas revenue, in-house game IPs, and higher non-operating income stemming from a strong cash position of KRW2.5tn as at end-1Q18.

See important disclosures, including any required research certifications, beginning on page 60

Netmarble Games (251270 KS): 11 July 2018

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook Netmarble: revenue mix and profitability outlook (KRWbn) We forecast Netmarble’s revenue to see a CAGR of 13.7% 3,600 30 over 2017-20E on strong revenue from core games such 3,000 25 as L2R. We forecast its overseas revenue to expand by 34% YoY in 2018 and 41% YoY in 2019, driven by the 2,400 20 ongoing launches of global versions of existing titles. And 1,800 15 we forecast Netmarble’s top-5 games to deliver c.58% of its game revenue in 2018, down from 63-74% in 2016-17. 1,200 10 600 5

0 0 2014 2015 2016 2017 2018E 2019E 2020E Domestic Overseas OPM (%, RHS)

Source: Company, Daiwa forecast

Valuation Netmarble: share-price trend and operating profit We attribute Netmarble’s weak share-price performance in 250 200,000 1H18 (traded in line with the KOSPI) mainly to investor 180,000 concerns about a fall in L2R revenue, a delay in the launch 200 160,000 140,000 of blockbuster mobile game B&S: Revolution, and a rise in 150 120,000 labour costs as a result of a hike in the minimum wage and 100,000 headcount. However, we highlight the company’s strategic 100 80,000 initiatives to enhance revenue mix in new games and new 60,000 markets, and diversify its business scope into various 50 40,000 entertainment segments. We forecast Netmarble’s EPS to 20,000 0 0 rise by 40% YoY in 2018 and to see a CAGR of 23.8% for 2017-05-01 2017-09-01 2018-01-01 2018-05-01 2017-20E. Operating profit (KRWbn, LHS) Share price (KRW, RHS)

Source: Company, FNdata, Daiwa forecasts

Earnings revisions Netmarble: Daiwa’s EPS forecasts vs. Bloomberg consensus

The Bloomberg consensus earnings forecasts have fallen (KRW) year to date, likely due a fall in L2R gamer traffic, the delay 10,000 9,000 in new game launches, and weaker-than-expected 1Q18 8,000 earnings. However, we expect the company to regain 7,000 6,000 earnings-growth momentum from 2H18, especially on a 5,000 HoH basis, with the release of major new game titles in 4,000 3,000 Asian and global markets. We also expect it to see strong 2,000 operating leverage with strong monetisation of its loyal 1,000 gamers, rising revenue from in-house game titles, and 0 May-17 Aug-17 Nov-17 Feb-18 May-18 effective control of operating costs. Consensus 2018 Consensus 2019 Daiwa forecast 2018 Daiwa forecast 2019

Source: Bloomberg, Daiwa forecasts

Netmarble Games (251270 KS): 11 July 2018

Financial summary Key assumptions Year to 12 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Top 5 game revenue % 0.0 0.0 52.0 63.4 74.1 57.5 59.4 51.0 Overseas revenue to total revenue % 0.0 26.4 29.9 50.9 33.4 37.0 44.7 47.2 Mobile revenue to total revenue % 0.0 81.1 92.2 95.8 97.4 97.8 98.0 98.1

Profit and loss (KRWbn) Year to 12 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Domestic 0 250 738 720 1,593 1,817 1,865 1,866 Overseas 0 89 314 747 799 1,069 1,507 1,668 Other Revenue 133 23 21 33 33 33 33 33 Total Revenue 133 362 1,073 1,500 2,425 2,919 3,404 3,567 Other income 0 0 0 0 0 0 0 0 COGS (60) (194) (588) (751) (497) (542) (612) (639) SG&A (55) (79) (259) (454) (1,418) (1,741) (1,965) (2,052) Other op.expenses 0 0 0 0 0 0 0 0 Operating profit 18 89 225 295 510 637 828 876 Net-interest inc./(exp.) (2) (1) 3 2 10 26 28 33 Assoc/forex/extraord./others (22) (28) 0 (22) (48) 28 28 28 Pre-tax profit (6) 60 229 276 471 691 884 936 Tax (1) (18) (60) (66) (111) (172) (219) (232) Min. int./pref. div./others 3 (18) (48) (35) (51) (33) (43) (45) Net profit (reported) (4) 25 121 174 310 487 622 659 Net profit (adjusted) (4) 25 121 174 310 487 622 659 EPS (reported)(KRW) (90) 524 2,130 2,817 4,104 5,724 7,318 7,750 EPS (adjusted)(KRW) (90) 524 2,130 2,817 4,104 5,724 7,318 7,750 EPS (adjusted fully-diluted)(KRW) (90) 524 2,130 2,817 4,104 5,724 7,318 7,750 DPS (KRW) 0 0 210 57 360 550 650 750 EBIT 18 89 225 295 510 637 828 876 EBITDA 25 102 248 325 574 713 912 968

Cash flow (KRWbn) Year to 12 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Profit before tax (6) 60 229 276 471 691 884 936 Depreciation and amortisation 7 13 23 31 65 76 84 92 Tax paid 3 (5) (31) (54) 56 (245) (295) (311) Change in working capital 2 (36) 41 (39) 38 (69) (68) (20) Other operational CF items 13 37 (74) (65) (147) (94) (35) (35) Cash flow from operations 19 69 188 149 483 360 571 662 Capex (19) (11) (25) (97) (33) (30) (31) (32) Net (acquisitions)/disposals 3 (182) (383) (104) (934) (336) (58) (60) Other investing CF items (18) (270) (72) (9) (454) (26) (30) (33) Cash flow from investing (34) (463) (480) (210) (1,421) (393) (119) (125) Change in debt 55 (35) 17 262 (45) (5) 5 6 Net share issues/(repurchases) 0 488 380 0 2,635 0 0 0 Dividends paid 0 0 (0) (1) (24) (47) (55) (64) Other financing CF items (15) 1 10 (147) (30) 0 0 0 Cash flow from financing 40 454 407 114 2,535 (52) (50) (58) Forex effect/others (1) (0) 1 4 37 0 0 0 Change in cash 23 60 117 57 1,635 (85) 402 479 Free cash flow 0 58 163 52 450 329 539 630 Source: FactSet, Daiwa forecasts

Netmarble Games (251270 KS): 11 July 2018

Financial summary continued … Balance sheet (KRWbn) As at 12 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Cash & short-term investment 43 257 331 420 2,551 2,674 3,093 3,589 Inventory 0 0 0 2 2 1 1 1 Accounts receivable 24 93 124 244 291 430 501 525 Other current assets 6 32 42 56 73 181 181 181 Total current assets 73 383 498 721 2,918 3,286 3,777 4,297 Fixed assets 17 23 26 123 145 149 148 143 Goodwill & intangibles 81 297 448 540 1,237 1,324 1,415 1,510 Other non-current assets 19 63 488 573 1,047 1,275 1,351 1,428 Total assets 189 766 1,458 1,957 5,348 6,034 6,691 7,379 Short-term debt 51 14 31 109 41 44 44 45 Accounts payable 6 41 68 109 121 88 92 95 Other current liabilities 31 68 145 204 340 537 542 548 Total current liabilities 88 123 245 421 501 669 678 688 Long-term debt 15 16 14 200 234 228 233 238 Other non-current liabilities 13 15 19 26 147 91 11 (74) Total liabilities 115 153 278 647 882 988 921 852 Share capital 1 1 1 7 9 9 9 9 Reserves/R.E./others 61 565 1,058 1,210 4,321 4,783 5,397 6,048 Shareholders' equity 62 566 1,059 1,216 4,329 4,792 5,406 6,056 Minority interests 13 47 122 94 136 255 364 471 Total equity & liabilities 189 766 1,458 1,957 5,348 6,034 6,691 7,379 EV 13,891 13,671 13,684 13,837 11,696 11,674 11,335 10,917 Net debt/(cash) 23 (228) (286) (110) (2,276) (2,402) (2,816) (3,307) BVPS (KRW) 307,736 2,104,825 71,062 17,953 50,935 56,373 63,595 71,248

Key ratios (%) Year to 12 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales (YoY) 98.1 171.8 196.1 39.8 61.7 20.4 16.6 4.8 EBITDA (YoY) n.a. 309.2 142.8 31.1 76.6 24.0 28.0 6.0 Operating profit (YoY) n.a. 400.3 153.9 30.7 73.0 25.0 30.0 5.8 Net profit (YoY) n.a. n.a. 391.5 44.3 78.1 57.1 27.8 5.9 Core EPS (fully-diluted) (YoY) n.a. n.a. 306.5 32.3 45.7 39.5 27.8 5.9 Gross-profit margin 54.9 46.4 45.2 49.9 79.5 81.4 82.0 82.1 EBITDA margin 18.7 28.2 23.1 21.7 23.7 24.4 26.8 27.1 Operating-profit margin 13.3 24.5 21.0 19.6 21.0 21.8 24.3 24.6 Net profit margin (2.7) 6.8 11.2 11.6 12.8 16.7 18.3 18.5 ROAE n.a. 7.8 14.8 15.3 11.2 10.7 12.2 11.5 ROAA n.a. 5.1 10.8 10.2 8.5 8.6 9.8 9.4 ROCE 15.1 22.7 24.1 20.7 16.0 12.7 14.6 13.6 ROIC 20.2 25.8 26.0 21.4 23.0 19.8 22.2 21.3 Net debt to equity 36.8 n.a. n.a. n.a. n.a. n.a. n.a. n.a. Effective tax rate n.a. 29.8 26.3 24.1 23.5 24.8 24.8 24.8 Accounts receivable (days) 48.4 59.3 37.0 44.8 40.3 45.1 49.9 52.5 Current ratio (x) 0.8 3.1 2.0 1.7 5.8 4.9 5.6 6.2 Net interest cover (x) 11.3 143.1 n.a. n.a. n.a. n.a. n.a. n.a. Net dividend payout n.a. 0.0 9.9 2.0 8.8 9.6 8.9 9.7 Free cash flow yield 0.0 0.4 1.2 0.4 3.2 2.4 3.9 4.5 Source: FactSet, Daiwa forecasts

Company profile

Netmarble Games is a leading mobile game company in Korea, with a 26.7% market share in 2016. It operates 21 game-development studios globally and had 64m monthly active users on average in 2017. The company derived 68% of its revenue overseas in 1Q18. The shares were listed on the Kospi on 12 May 2017.

Netmarble Games (251270 KS): 11 July 2018

Investment conclusions

Game IP assets likely to shine from 2H18 Blockbuster games are We raise our 12-month target price for Netmarble to KRW188,000 from KRW171,000, on a on the launch pad new target 2018-19E PER of 28.8x (from 28.2x,a 22% premium to its global peers’ average 2018-19E PER of 23.6x, on Bloomberg consensus forecasts) applied to our revised 2018- 19E earnings (from 2018E). We reiterate our Buy (1) rating on Netmarble as we expect a robust earnings-growth cycle from 2H18 upon the rollout of blockbuster mobile RPGs (Blade & Soul: Revolution, Seven Knights 2, and BTS World), service-region expansion into Japan and the US, and strong operating leverage.

Three reasons to buy In 1H18, Netmarble did not roll out any major new games titles due to its focus on game quality and target-market expansion into the US and Japan. We believe there are three reasons to buy the company’s shares going into 2H18 and 2019, on an improving outlook for its core game business.

 New blockbuster games likely to be rolled out. We expect Netmarble to roll out 18 new mobile games, including B&S: Revolution, Seven Knights 2, and other exclusive mobile games in 2018-19. With enhanced revenue streams on the back of new commercial titles, the mobile-game developer is set for a robust earnings-growth cycle from 2018, in our opinion.

 Increasing business scale overseas. Netmarble has gained success in the US and EU game markets with its IP-based games (Harry Potter: Hogwarts Mystery and Marvel: Future Fight), while setting solid foundations for global expansion with its new mobile games. In 2018-19, we believe the launch of new games like Lineage 2: Revolution into China will drive strong top-line growth for Netmarble. We forecast its overseas game revenue to see a CAGR of 27.8% and account for 37-47% of its total revenue over 2018-20.

 Rapidly evolving with new technologies. We expect Netmarble to pursue a disciplined growth strategy to boost its revenue and earnings growth, focusing on effective monetisation of its vast gamer base, tight controls on operating expenses, and nimble acquisition of game-development studios and talent, and popular IPs globally. We expect Netmarble’s EPS to expand at a CAGR of 23.8% over 2017-20E on solid operating leverage as a result of revenue from new games and rapid AI adoption.

Valuation Well-positioned to Netmarble shares have performed in line with the KOSPI in the YTD, while the company’s capitalise on rising core game sales remained soft in 1Q18. The stock is trading currently at PERs of 28.5- mobile game spending 22.3x on our 2018-19E earnings forecasts. We look for the shares to perform more strongly from 3Q18 and potentially see a valuation rerating on the back of growth in game revenue globally, driven by new IP-based games, large-scale content updates for flagship games, and a disciplined cost strategy for marketing and promotion.

Despite investor concerns on the company’s recent moves in non-game segments, we believe Netmarble will be able to realise business synergies with its core game services, helped by advanced AI and other next-generation technologies (AR and VR). We would highlight to investors the company’s strong platform assets (vast user data, transaction information for in-game item commerce, proven game-service expertise in Asia, and robust cash-generating capability) when taking into account its valuation.

In the near term, we also see the following factors as potential share-price catalysts: launch of B&S: Revolution and overseas expansion of IP-based games (Seven Knights 2 and BTS World).

Netmarble Games (251270 KS): 11 July 2018

Netmarble: PER bands

(KRW) 49.3x 43.5x 37.7x 200,000

180,000 31.8x

160,000

140,000 26.0x 120,000

100,000 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18

Source: DATAguide, Company

Netmarble: EV/EBITDA bands

(KRW) 25.4x 200,000 22.9x 180,000 20.5x

160,000 18.1x

140,000 15.6x 120,000

100,000 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Source: DATAguide, Company

Netmarble Games* 251270 KS Buy (1) 12.4 28.5 22.3 16.4 12.4 20.4 16.6 39.5 27.8 10.7 12.2 21.8 24.3 NCsoft* 036570 KS Buy (1) 7.6 16.6 11.9 8.7 6.1 12.1 18.6 15.8 39.1 17.1 19.9 36.7 41.2 Com2uS* 078340 KS O/P (2) 2.0 12.4 10.5 6.2 4.6 16.0 14.8 29.5 17.8 21.9 21.2 38.8 39.9 Kakao* 035720 KS Buy (1) 8.0 41.5 35.5 19.9 15.3 24.4 13.9 59.7 16.8 4.2 5.0 11.4 13.5 Pearl Abyss 263750 KS Not rated 2.5 13.6 9.2 9.8 5.5 N.A. 44.8 191.5 47.5 50.8 46.7 51.8 54.7 Korea average-ex Netmarble 21.0 16.8 11.2 7.9 17.5 23.0 74.1 30.3 23.5 23.2 34.7 37.3

Tencent Holdings* 700 HK Buy (1) 468.4 34.0 25.8 26.4 20.8 51.8 40.0 37.7 32.8 28.6 26.7 21.8 17.9 NetEase* NTES US Buy (1) 35.1 22.0 17.7 14.5 11.2 32.1 25.1 -17.0 24.9 20.9 21.8 17.0 17.0 China average 28.0 21.7 20.5 16.0 42.0 32.5 10.4 28.8 24.7 24.2 19.4 17.5

Global average-ex Netmarble 27.2 21.2 12.5 10.0 14.8 13.3 35.5 20.6 19.6 19.3 27.2 28.1

Source: *Daiwa forecasts, Bloomberg.

Netmarble Games (251270 KS): 11 July 2018

AI history and R&D capabilities

AI milestone initiatives AI experience: began Netmarble first entered into AI with an internal AI project named Columbus, an AI-based with the Columbus engine for personalised game services, in 2014. It aimed to provide customised game project in 2014 services (marketing, promotional events, and official notices) for each gamer, based on user profile and gameplay style. The company has been using this game-service engine for a number of commercial titles and aims to apply it to its new mobile games as well.

At the beginning of the Columbus project, Netmarble’s engineers focused on building the AI system, which leverages the company’s expertise in game operation to develop an AI system, with continued upgrades for commercial services. The company has tested various machine-learning models and aims to incorporate AI technology to improve the user experience, based on the Big Data it has accrued from its long history of game operations in Korea and overseas.

Netmarble: a brief history of the AI division Year Key developments 2014 Initiated research on Columbus (customised game service engine) Sep 2017 AI Forum for all of Netmarble’s engineers Feb 2018 Announced new AI strategy at its Netmarble Together with Press (NTP) event Mar 2018 Established its AI Centre Mar 2018 Dr. Lee Juhn-Young joined the company as the head of its AI centre 2018 Preparing to establish an AI lab in North America

Source: Company, Daiwa

We believe the company aims to use AI technology to expand from the game industry, and evolve into entertainment content globally, by leveraging an improved industry value chain from development to distribution and operation. By using AI technology, we believe the company can improve the overall operational efficiency of all of its business segments.

The leader of Netmarble’s AI Centre A new era with the hire On 6 March 2018, Netmarble announced that it had appointed Lee Juhn-Young, PhD, as of AI guru from IBM the head of Netmarble’s AI Centre. According to the company, Dr. Lee has a strong research background and experience in advanced technologies, such as AI, machine learning, Big Data, cloud computing, and blockchain.

Dr Lee has over 20 years of experience at IBM’s Thomas J. Watson AI Lab in the US, where its research focus has been expanding into various IT centre domains including next-generation IT platform development and IT service strategies.

In our view, Netmarble will ramp up its AI strategic initiatives following the hiring of Dr. Lee, and accelerate the upgrade of its ‘Columbus’ project from 2018. Through its enhanced AI R&D capability, we believe the company will move to take advantage of its Columbus engine, using it to improve live-game operations, customer service, new game development, with potential applications to new entertainment services, along with virtual reality and augmented reality.

Netmarble: key personnel in the AI division Category Description Name Dr. Lee Juhn-Young Age Born in 1963 (age: 55) Education Computer Science, Seoul National University Doctor of Computer Science, University of Virginia

Key research areas AI, big data, cloud computing, and blockchain Work experience IBM Watson AI Lab

Source: Company, compiled by Daiwa

Netmarble Games (251270 KS): 11 July 2018

AI, games, and business strategy

Ready to ramp up AI adoption in all of its businesses Looking for AI Since 2014, Netmarble has been striving to improve its game operations, based on its opportunities in game Columbus engine. With its vast dataset from its long history of game services for mobile and non-game markets and the overseas market, we believe the company has focused on enhancing its game business in terms of cost efficiency and user monetisation.

Meanwhile, we believe the company has changed its AI strategy since 2017, by expanding AI adoption into new game development as well as its new entertainment businesses.

Netmarble first incorporated AI technology in one of its games when it published Iron Throne, a mobile strategy MMO (massively multiplayer online) game, which was developed by 4Plat (unlisted), in May 2018. Iron Throne is characterised by a variety of combat systems such as Battle Royale mode and 20 vs. 20 team death match.

Netmarble: Iron Throne screenshot

Source: Company

Powering AI technology In our view, both the company and the third-party developer (4Plat) have incorporated AI with VR and AR technology into Iron Throne’s 20 vs. 20 team battle mode to sharpen the gamer experience through the use of AI-programmed non-player characters (NPCs). If the match does not attract enough people before it starts, the game uses AI in place of real game players to maintain the balance between the two sides.

The strategy MMO game also offers a hunting mode, based on AR technology, where gamers can share AR experiences with gamers from different countries.

Netmarble: key features of AI adoption Columbus, Netmarble’s AI engine Iron Throne's team death match content requires 20 players in each team. Should one side lack players, AI fills up the player Current slots to maintain the balance between two parties Future Customised game-play guide Applying different billing structure according to players' purchasing pattern

Providing user-customised events

New technologies AR: Iron Throne and Fishing Strike VR: Fishing Strike

Source: Company

Netmarble Games (251270 KS): 11 July 2018

AI strategy and new business initiatives From Columbus to an AI We believe there are three areas where Netmarble can utilise AI technology: 1) in new platform for new games game development to offer innovative game features, 2) to ensure efficient game operations, and 3) in new services involving other entertainment content. Bang Joon-Hyuk, chairman of Netmarble, reiterated the company's AI strategy at its Netmarble Together with the Press (NTP) event held in February 2018, highlighting that the next-generation games are likely to be “more intelligent” and have more social features compared with existing games.

According to management, the company has a strong knowledge of the gaming industry, as well as gamer characteristics, which could be its strongest assets when leveraging AI technology in the long term. We expect the company to continue to use AI technology for different game genres, such as strategic simulation, casual games, and puzzle games, and enhance its AI system with more personalised features for billing, promotion and gameplay.

In our view, the Columbus engine is still the key driver of Netmarble’s AI strategy, as the company is ready to ramp up adoption of Columbus into commercial games from 2018. Netmarble developed Columbus as a software development kit (SDK). As a result, we believe the company can share its game-development modules and library with other game developers and related partners. Given that the company has been acquiring game- development studios overseas (eg, Jamcity in July 2015, Tiny Co in July 2016, and Kabam in February 2017), especially in North America, management expects the company to capitalise on its overseas AI lab through the sharing of R&D.

Looking for AI Over 2018-20, we believe Netmarble’s AI focus will be on enhancing the gamer experience opportunities in its live mobile games. More specifically, Netmarble aims to collect gamer traffic data and analyse user information such as the degree of player competency and game adaptability, in-game item usage, and purchasing patterns, in order to provide better game-play guidance, identify a better billing structure, and provide customised promotion information.

Meanwhile, we expect its Columbus AI system to provide more opportunities to capitalise on a strong gamer base globally, by increasing gamer retention and in-game item spending over the long term. The company noted that its AI-based system for more personalised game services (Columbus) gained positive feedback from gamers, in terms of longevity of game, in-game item transactions, and total number of user complaints related to game operation.

Netmarble’s strategic focus for AI technology is to develop an intelligent game which can be played and customised according to gamer skill levels. AI could also be used to help gamers solve tough quests, rather than using credits to complete the quest. Given Netmarble’s focus on AI technology, we expect more immersive gameplay and a better gaming experience going forward.

Netmarble Games (251270 KS): 11 July 2018

Earnings outlook

Earnings outlook for 2H18 and 2019-20E Moving up the value We have become more positive on Netmarble’s earnings-growth prospects for 1H18 and chain globally 2019-20 as the company plans to speed up its expansion in Japan, the US and the EU through various new games, based on popular IP and subsequent sequels. With its increasing scale of game operations globally, we expect the company to record revenue growth from 2H18, helped by major content updates for its core mobile games in Korea.

Netmarble: revenue mix and profitability outlook (KRWbn, 2014-20E) 3,600 30

3,000 25

2,400 20

1,800 15

1,200 10

600 5

0 0 2014 2015 2016 2017 2018E 2019E 2020E Lineage 2: Revolution Marvel Contest of Champions Cookie Jam Everyone's Marble Seven Knights Marvel: Future Fight Blade & Soul MMORPG Others OPM (%, RHS) Source: Company, Daiwa forecast Note: *Others include mobile games (Harry Potter, Tera M and others) and online games (MaguMagu and others)

Netmarble said it plans to launch 8 new mobile games in Korea in 2H18-19. We believe the company will focus on mid-to-hard core mobile games, which generate relatively high ARPUs and have relatively long life cycles; but it may face tough competition acquiring new gamers and promoting in-game item sales. Of its game pipeline for 2H18 onwards, management has high expectations for three major mobile RPGs: B&S: Revolution, Seven Knights 2, and BTS World, which is based on real-life characters from the popular K-pop boy band BTS.

Netmarble: new game launches in 2018-19 Genre Developer details and description

Korea

Blade & Soul: Revolution MMORPG Martial arts fantasy game, Developed by Cherry Bucks based on NCsoft's IP Publishing deal with Tencent to target Chinese market

Seven Knights 2 Collection MMORPG Developing Seven Knights for Nintendo Switch based on Unreal Engine 4, sequel to Seven Knights Knights of the Round Table MMORPG Battle game, real time open world Stone Age Begins MMORPG Turn-based MMORPG, mobile version of Stone Age online game Koongya Catchmind Casual Drawing quiz, social network game Koongya Green Village Casual RPG Based on Netmarble's life simulation game

Overseas

Knights Chronicle (launched 14/06/18) Turn-based RPG Targets release in 140 countries including Korea, Anime-style 3D graphics, Raids in multiplayer dungeons Fishing Strike (launched12/04/18) Sports Sports Fishing Game, Developed by Wemadeplus Harry Potter: Hogwarts Mystery (launched 25/04/18) Adventure RPG Based on famous fantasy novel, "Harry Potter" Developed by Jamcity

Iron Throne (launched 16/05/18) Strategy MMO Netmarble's first mobile strategy MMO game, targets global markets including Korea, developed by 4Plat and Netmarble Teria Saga (launched 24/05/18) Collection RPG Launched in Japan BTS World Adventure RPG Targets Korea and North America, collaboration with TakeOne Company, real-picture type cinematic game Contains 1,000 photos and 100 video clips of BTS, an iconic seven-member boy band in Korea

The King of Fighters All Star Action RPG Targets Japan, Battle Game, developed by Netmarble Neo The Seven Deadly Sins (tentative title) RPG Targets Japan, based on popular animation in Japan Magu Magu Sports Targets Japan, localised for the Japanese market, popular game in Korea and Taiwan Yokai Watch Medal Wars (tentative title) Action RPG Targets Japan, based on popular animation in Japan Phantom Gate Adventure RPG Maze, puzzle, battle game based on Northern European mythology Lineage 2: Revolution MMORPG Targets China, Tencent-led marketing and localisation Rich Ground (tentative title) Board RPG Global version of Everybody's Marble, tournament available with global users G.I.Joe Strategy Targets North America and Europe Trendy Town MMORPG Targets North America, real time social network game Magic the Gathering M (tentative title) MOBA Developed by Netmarble Monster with Wizards of the Coast, real time multiplayer battling game

Source: Company, compiled by Daiwa Note: shaded games are slated to be released in 2H18

Netmarble Games (251270 KS): 11 July 2018

We forecast Netmarble’s revenue to see a 13.7% CAGR over 2017-20E, with its top-5 games contributing 51-59% of total revenue over the period. Meanwhile, we expect Netmarble to record operating-profit margins of 21.8-24.6% for 2018-20E, while spending 14.2-14.5% of its total revenue on marketing as it plans to ramp up global expansion, boost gamer traffic in Asia, and retain loyal players in Korea. Assuming a mild increase in its headcount for its core game-development studios, we expect its cost structure to stabilise over our forecast horizon. We forecast Netmarble’s EPS to see a CAGR of 23.8% for 2017-20E, on solid growth in revenue from its franchise mobile games and a sharp rise in overseas royalty revenue, along with a disciplined cost strategy for marketing and sales commissions.

2Q18 preview IP-based mobile games For 2Q18, we forecast Netmarble’s revenue to rise 9.9% YoY to KRW0.59tn on solid will likely shine in 2Q18 revenue from its flagship mobile games (L2R) in Korea and overseas and soft performance of newly launched games. We also forecast it to record operating profit of KRW101.7bn (down 3.3% YoY) and an operating-profit margin of 17.1%. Going forward, we expect Netmarble to regain its revenue and earnings-growth momentum from 2H18, driven by the launch of new blockbuster mobile games globally, monetisation of its existing gamers, and operating leverage.

Netmarble: quarterly earnings trends (3Q16-2Q18E) (KRWbn) 2Q18E

3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 Daiwa Consensus

Revenue 359.0 463.0 687.2 540.1 581.7 615.8 507.4 593.5 584.6 YoY growth(%) 27.4 34.7 110.7 53.5 62.0 33.0 (26.2) 9.9 8.2 QoQ growth(%) 2.1 28.9 48.4 (21.4) 7.7 5.9 (17.6) 17.0 15.2 Operating profit 64.6 118.1 200.1 105.1 111.8 92.7 74.2 101.7 103.5 YoY growth(%) 13.9 80.0 234.6 99.8 73.1 (21.5) (62.9) (3.3) (1.5) QoQ growth(%) 22.8 82.8 69.4 (47.5) 6.4 (17.1) (20.0) 37.1 39.6 OP margin(%) 18.0 25.5 29.1 19.5 19.2 15.1 14.6 17.1 17.7

Source: Bloomberg, Company, Daiwa forecast

Along with solid revenue from third-party game titles in 2Q18, we expect steady growth of in-game item sales from both new and old game titles. We look for Netmarble to deliver strong earnings growth from 2H18, driven by a rebound in gamer traffic for L2R (following content updates for this game), strong revenue for quality mobile MMORPGs, and operating leverage as a result of effective monetisation of its core gamers and tight control of operating expenses.

Earnings-forecasts revisions AI systems to lead to Park Sung-Hoon, Netmarble’s CEO, reaffirmed that Netmarble will continue to focus on the lower operating costs in mobile game market in order to become a global leader and likely invest in three areas: 1) 2019-20E powerful IP, 2) game-related technologies like AI, and 3) new game genres such as shooting and celebrity-based gameplay. Management has relatively high expectations for its RPGs, such as B&S: R, Seven Knight 2 and The King of Fighters, especially in Japan, which could be positive for its revenue and earnings from 2H18.

We lower our 2018E EPS by 5.6% to factor in the likely weaker-than-expected 2Q18 results, management’s revised cost strategy for software engineers and global marketing for new game launches, and advanced mobile-game-related technology investment. But, we raise our 2019-20E EPS by 6.8-6.9% to reflect Netmarble’s expansion in Japan, the US and the EU through various new games, based on popular IPs and their sequels, as well as cost benefits from AI systems.

Netmarble Games (251270 KS): 11 July 2018

Netmarble: earnings-forecast revisions (KRWbn) Previous New Revision (%) 2018E 2019E 2020E 2018E 2019E 2020E 2018E 2019E 2020E

Revenue 3,015 3,435 3,581 2,919 3,404 3,567 (3.2) (0.9) (0.4) Operating profit 689 796 840 637 828 876 (7.5) 3.9 4.2 Net profit 515 582 617 487 622 659 (5.6) 6.9 6.8 EPS 6,057 6,843 7,258 5,724 7,318 7,750 (5.6) 6.9 6.8

Source: Daiwa forecast

Major investment Risks concerns In our view, the major risks to our investment case are: 1) a delay in new game launches in major markets (Korea, Japan, and China), 2) a gamer exodus to competitors’ new mobile games, and 3) cost and investment risks associated with any aggressive M&A initiatives to acquire game-development studios and popular IPs.

Japan Information Technology 11 July 2018

Nexon (3659 JP) Nexon

Target price: JPY2,150 (from JPY2,200) Share price (10 Jul): JPY1,675 | Up/downside: +28.4%

Entering a multi-year earnings growth cycle from 2H18

 A top hybrid company with solid earnings and new games pipeline Thomas Y. Kwon (82) 2 787 9181  Core games to propel strong revenue and earnings growth from 2H18E [email protected]  Reiterating our Buy (1) rating; lowering TP to JPY2,150

What's new: We are more positive on Nexon’s ability to capitalise on Forecast revisions (%) young consumers’ willingness to spend on game content. We forecast Year to 31 Dec 18E 19E 20E Nexon to enter a strong multi-year revenue and earnings growth cycle from Revenue change - 0.5 0.8 2H18 by comprehensively diversifying its game genres and service regions. Net profit change (4.2) (2.2) (0.9) Core EPS (FD) change (4.4) (2.5) (1.2)

Source: Daiwa forecasts What's the impact: FIFA Online 4 and Kaiser hits in Korea, besides FIFA Online 3 and HIT. Nexon’s new games, FIFA Online 4 and Kaiser, Share price performance have been ranked No.5 and No.7 on the top revenue-grossing apps lists at (JPY) (%) both Android and iOS app stores in Korea since their launch in June 2018. 2,000 170 We view this robust performance in Korea as a positive, given Korea is one 1,750 150 of the most competitive game markets globally and it is hard to acquire new 1,500 130 gamers. We expect Nexon to succeed in cross-promoting new games and 1,250 110 1,000 90 selling in-game items effectively during 2H18-2019. Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Nexon (LHS) Relative to TOPIX Index (RHS) Sound strategy in place to penetrate global markets. In our view, Nexon has a robust strategy in place to penetrate global markets with various 12-month range 1,099-1,995 high-quality new mobile games, rather than a single big game. By Market cap (USDbn) 13.41 leveraging on existing paying gamers in the Pan-Asia region, we expect 3m avg daily turnover (USDm) 40.95 Nexon to attract more young gamers, increase traffic for item commerce, Shares outstanding (m) 891 Major shareholder NXC (28.4%) and extend the lifecycle of its commercial titles. We forecast Nexon to increase its overseas revenue by 25% YoY in 2018 and 10% YoY in 2019. Financial summary (JPY) Year to 31 Dec 18E 19E 20E Optimising its business model with technology. We contend that the Revenue (bn) 278 300 312 leading gaming companies in Korea will benefit from the use of advanced Operating profit (bn) 119 132 141 Net profit (bn) 103 109 114 AI technologies to optimise their cost structures and create new business Core EPS (fully-diluted) 117 122 128 value from core games. We forecast Nexon’s operating-profit margin to rise EPS change (%) 80.0 4.7 4.7 to 44-45% over 2019-20, from 39-43% in 2017-18, led by ongoing efforts to Daiwa vs Cons. EPS (%) 12.2 6.5 7.5 PER (x) 14.3 13.7 13.1 lower SG&A costs, together with strong overseas royalties. We cut the Dividend yield (%) 0.0 0.0 0.0 2018-20E EPS by 1-4% to reflect our assumptions of high labour costs for DPS 0 0 0 new game development in Korea and marketing costs for new launches. PBR (x) 2.5 2.2 1.9 EV/EBITDA (x) 8.5 6.9 5.8

ROE (%) 19.3 17.0 15.6 What we recommend: We reiterate our Buy (1) rating and lower our 12- Source: FactSet, Daiwa forecasts month TP to JPY2,150 (from JPY2,200), based on an unchanged target PER of 18x, applied to our revised 2018-19E adjusted fully-diluted EPS average (from 2018E). We expect the launches of blockbuster games for PC and smart devices in Korea and globally to boost its earnings, and see the stock performing strongly over 2018-20E. Key risks: a sharp drop in core online-game traffic in China and Korea, and delayed game launches in key Asian markets.

How we differ: Our 2018-20E EPS are 7-12% above the consensus, likely on our more positive view of strong earnings contributions from new in- house games and lucrative overseas royalties.

See important disclosures, including any required research certifications, beginning on page 60

Nexon (3659 JP): 11 July 2018

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook Nexon: revenue and operating-profit margin (JPYbn) We forecast Nexon’s revenues from Korea and China to 350 50 increase at CAGRs of 7.2% and 3.8%, respectively, for 300 2017-20, on the back of a number of scheduled new 40 250 mobile-game launches. By promoting new games through 30 its global platforms, we expect the company to record a 200 steady rise in the number of paying gamers and ARPU for 150 20 its core game titles in Asia. In terms of customer base, we 100 10 expect its revenue mix for 2018 to be: Korea (31%), China 50 (51%), and others (18%); and by platform: mobile (29%) 0 0 and online PC (71%). 2010 2011 2012 2013 2014 2015 2016 2017 2018E 2019E 2020E Total revenue OPM (%, RHS)

Source: Company, Daiwa forecast

Valuation Nexon: share-price trend and operating profit Nexon shares are currently trading at respective PERs of 60 2,500 14.3x and 13.7x on our 2018E and 2019E EPS -- lower 50 2,000 than the average 2018E/2019E PERs of 28.3x/21.8x of the 40 leading game developers globally (based on our and the 1,500 Bloomberg-consensus EPS forecasts for 2018-19). With a 30 number of games lined up for 2018-19E and scheduled 1,000 content updates of its key games, Nexon’s earnings growth 20 500 momentum should continue over 2018-20, and we 10 anticipate a re-rating in valuation over the medium term. 0 0 2015-01-01 2016-01-01 2017-01-01 2018-01-01 Operating profit (JPYbn, LHS) Share price (JPY, RHS)

Source: Company, FNdata, Daiwa forecasts

Earnings revisions Nexon: Daiwa’s EPS forecasts vs. Bloomberg consensus

The Bloomberg-consensus 2018-19 EPS estimates for (JPY) Nexon have been revised up since 2H17, driven by 180 stronger-than-expected revenue from China and solid 160 revenue from its core online games in Korea for 1Q18. 140 120 Our 2018-19E EPS are 7-12% higher than the consensus, 100 as we have factored in the stronger-than-expected 1Q18 80 results, robust earnings from its core online games in 60 Korea and China over 2018-19E, and improving visibility 40 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 on new mobile-game launches in the Pan-Asia region. Consensus 2018 Consensus 2019

Daiwa forecast 2018 Daiwa forecast 2019 Source: Bloomberg, Daiwa forecasts

Nexon (3659 JP): 11 July 2018

Financial summary Key assumptions Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Ex-Japan revenue portion (%) 76.6 82.7 89.1 91.6 94.8 95.5 90.7 89.7 Revenue contribution from Korea (%) 27.7 37.8 40.5 40.5 34.3 30.8 29.5 31.8 Mobile game revenue portion (%) 18.3 19.8 22.1 23.7 21.9 28.9 38.9 44.4

Profit and loss (JPYbn) Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Korean customers Revenues 43 65 77 74 81 86 89 99 Chinese customers Revenues 64 67 75 74 115 141 135 129 Other Revenue 48 41 38 35 39 51 76 84 Total Revenue 155 173 190 183 235 278 300 312 Other income 2 1 1 1 1 1 1 1 COGS (34) (44) (50) (48) (57) (60) (65) (68) SG&A (60) (69) (74) (66) (75) (93) (97) (97) Other op.expenses (13) (16) (5) (29) (14) (7) (7) (7) Operating profit 51 46 62 41 91 119 132 141 Net-interest inc./(exp.) (2) 7 6 6 (14) (5) (12) (6) Assoc/forex/extraord./others (0) (0) 0 0 (6) 14 14 11 Pre-tax profit 49 53 68 47 70 128 135 146 Tax (18) (23) (12) (27) (13) (25) (26) (32) Min. int./pref. div./others (0) (0) (0) (0) 0 0 0 0 Net profit (reported) 30 29 55 20 57 103 109 114 Net profit (adjusted) 30 29 55 20 57 103 109 114 EPS (reported)(JPY) 69 67 127 46 130 155 122 128 EPS (adjusted)(JPY) 69 67 127 46 130 155 122 128 EPS (adjusted fully-diluted)(JPY) 34 34 64 23 65 117 122 128 DPS (JPY) 10 10 10 5 5 0 0 0 EBIT 51 46 62 41 91 119 132 141 EBITDA 65 61 75 47 96 125 144 152

Cash flow (JPYbn) Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Profit before tax 49 53 68 47 70 128 135 146 Depreciation and amortisation 14 16 13 6 6 5 11 11 Tax paid (39) (45) (35) (42) (29) (25) (26) (32) Change in working capital 9 (2) (3) 0 (13) (19) (24) (3) Other operational CF items 28 37 18 62 46 (5) (2) (2) Cash flow from operations 60 58 60 73 81 85 94 120 Capex (9) (5) (3) (2) (2) (3) (3) (3) Net (acquisitions)/disposals (40) (48) 82 (76) (61) (51) (18) (19) Other investing CF items 43 (9) (23) (19) (19) 3 0 0 Cash flow from investing (6) (62) 56 (97) (82) (51) (21) (22) Change in debt (16) (12) (33) (2) 1 (1) (2) 0 Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (4) (4) (4) (4) (4) (2) 0 0 Other financing CF items 7 (11) 2 (3) 0 0 0 0 Cash flow from financing (13) (27) (36) (9) (3) (3) (2) 0 Forex effect/others 14 10 (4) (8) 5 0 0 0 Change in cash 54 (21) 76 (42) 1 32 71 98 Free cash flow 51 54 57 71 79 82 91 117 Source: FactSet, Daiwa forecasts

Nexon (3659 JP): 11 July 2018

Financial summary continued … Balance sheet (JPYbn) As at 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Cash & short-term investment 182 218 291 326 387 428 499 597 Inventory 0 0 0 0 0 0 0 0 Accounts receivable 22 32 33 27 35 54 78 81 Other current assets 13 8 7 13 20 24 26 27 Total current assets 218 258 332 366 443 505 602 704 Fixed assets 22 24 22 20 27 25 21 17 Goodwill & intangibles 72 52 43 25 34 31 27 23 Other non-current assets 107 103 29 31 42 125 103 123 Total assets 419 437 426 442 546 686 753 867 Short-term debt 13 13 2 2 3 3 2 2 Accounts payable 10 10 11 9 9 8 8 9 Other current liabilities 27 34 24 24 29 33 35 37 Total current liabilities 50 57 37 35 42 44 46 47 Long-term debt 37 25 3 1 1 1 1 1 Other non-current liabilities 18 9 6 28 34 29 27 26 Total liabilities 106 92 46 64 76 74 73 73 Share capital 52 52 56 4 9 12 12 12 Reserves/R.E./others 257 288 318 369 456 595 664 778 Shareholders' equity 308 340 374 373 465 606 676 790 Minority interests 5 5 5 5 5 5 5 5 Total equity & liabilities 419 437 426 442 546 686 753 867 EV 1,362 1,316 1,209 1,168 1,105 1,061 985 884 Net debt/(cash) (132) (180) (286) (323) (383) (424) (497) (594) BVPS (JPY) 702 789 863 858 1,057 681 758 886

Key ratios (%) Year to 31 Dec 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales (YoY) 43.3 11.3 10.0 (3.8) 28.3 18.5 7.7 4.1 EBITDA (YoY) 6.6 (5.6) 23.3 (37.6) 104.8 29.4 15.3 6.0 Operating profit (YoY) 7.3 (10.2) 36.9 (34.7) 122.6 31.8 11.1 6.6 Net profit (YoY) 6.5 (2.7) 88.1 (63.5) 181.9 82.2 5.3 4.7 Core EPS (fully-diluted) (YoY) 4.9 (2.2) 89.2 (63.6) 179.9 80.0 4.7 4.7 Gross-profit margin 78.0 74.4 73.9 73.7 75.9 78.4 78.4 78.4 EBITDA margin 41.7 35.4 39.6 25.7 41.0 44.8 48.0 48.9 Operating-profit margin 32.6 26.3 32.7 22.2 38.5 42.8 44.2 45.3 Net profit margin 19.4 17.0 29.0 11.0 24.2 37.2 36.3 36.6 ROAE 11.6 9.0 15.4 5.4 13.5 19.3 17.0 15.6 ROAA 8.2 6.9 12.8 4.6 11.5 16.8 15.1 14.1 ROCE 15.7 12.2 16.2 10.6 21.2 21.9 20.4 19.1 ROIC 18.9 14.7 39.3 23.8 103.1 70.2 57.6 57.4 Net debt to equity n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Effective tax rate 37.7 44.1 18.2 56.5 19.3 19.3 19.3 22.0 Accounts receivable (days) 51.4 57.8 63.0 60.2 48.4 58.2 80.0 92.9 Current ratio (x) 4.3 4.5 9.0 10.5 10.7 11.4 13.2 15.0 Net interest cover (x) 25.8 n.a. n.a. n.a. 6.4 23.8 10.9 22.4 Net dividend payout 14.5 14.8 7.8 10.8 3.9 0.0 0.0 0.0 Free cash flow yield 3.4 3.6 3.8 4.7 5.3 5.5 6.1 7.8 Source: FactSet, Daiwa forecasts

Company profile

Nexon is a leading online-game developer, and a publisher domiciled in Korea. The company publishes a range of casual games that are particular to the online game industry, and uses free-to- play revenue model. It offers more than 60 games in over 100 countries. The company had 35.3m monthly active users at the end of 1Q18. Nexon was listed on the Tokyo Stock Exchange on 14 December 2011.

Nexon (3659 JP): 11 July 2018

Investment conclusion

The best hybrid game developer for all platforms Entertaining young In our view, Nexon has a strong line-up of new games for 2H18-2019, supported by the consumers with rollout of popular sequel online PC games, new mobile games with advanced gamer appealing games interfaces, and foreign-made games for local users. These titles, in addition to FIFA Online 4 (released on 17 May) and Kaiser, a mobile RPG, provide good visibility on new game launches by Nexon in 2018, in our view. Besides, we remain confident of its earnings- generation capability through Dungeon and Fighter (DNF) in China, and see the company benefiting from the expansion of its service regions with high-quality mobile games globally.

Three reasons to buy 1) visible business In our opinion, Nexon will continue to pursue a smart strategy with its new game launches, momentum, 2) new whereby it rolls out new games in Korea first and then ramps up into the Pan-Asia region. games, and 3) We see compelling investment factors for Nexon currently, as we expect solid revenue and compelling game line-up earnings growth drivers from 2H18.

 Visible business momentum. Compared with its regional peers, Nexon has a more diverse game portfolio for 2H18 and 2019, ranging from online PC games to mobile games featuring casual and sports titles. We expect the company’s vast gamer base globally to continue to increase spending on new game content and in-game items from 2H18. Hence, we forecast Nexon’s revenue to expand at a CAGR of 10% over 2017-20. Through its aggressive adoption of AI technologies, we believe Nexon’s earnings visibility will steadily improve, supported by lower costs for game operation and new game development.

 New games should thrive in Asia and possibly China. Nexon plans to release 6 mobile games and 4 online PC game titles in 2H18. Although the launch date of DNF Mobile has yet to be finalised, we expect significant revenue upside from China once the company’s popular mobile games start offering commercial services there. In terms of customer base, we expect its revenue mix for 2018 to be: Korea (31%), China (51%), and others (18%); and by platform: mobile (29%) and online PC (71%).

 Arguably the strongest line-up of new games for 2H18-2019. Strategically, Nexon has been postponing the commercial launches of new big titles into 2H18, and even 2019, in order to improve game quality and respond to gamers’ demands in terms of gameplay and content. We believe Nexon’s game portfolio for 2018-19 is very strong compared with its peers’, given the diverse range of genres, the popularity of its game IP, and entry into new service regions, including three key Asian markets (Korea, China and Japan).

Valuation thoughts We expect the China We reiterate our Buy (1) rating and lower our 12-month TP to JPY2,150 (from JPY2,200), market to boost Nexon’s based on an unchanged target PER of 18x, the average of global peers (the Bloomberg- performance over consensus forecasts for 2018-19), applied to our revised 2018-19E adjusted fully diluted- 2018-20 EPS average (from 2018E). With the successful rollout of new blockbuster games in Korea and Asia, we expect Nexon to enter a multi-year earnings growth cycle from 2H18 and its shares to perform strongly from 2H18.

Nexon’s shares have traded at a discounted PER of 10.4-21.6x over 2011-17 vs. global peers. We attribute this prolonged discount in valuation to the: 1) high revenue dependency on its DNF online game in China, and 2) relatively high revenue from third- party publishing games.

However, we believe that Nexon has strong and sustainable revenue streams, based on steady and visible lucrative revenue from its addressable target markets in Asia, effective monetisation of its vast paid gamer base through Big Data analytics and AI systems, and ongoing initiatives to broaden its revenue mix in terms of platform and region.

Nexon (3659 JP): 11 July 2018

Risks to our call Key downside risks to our call include a sharp drop in core online-game traffic in China and Korea, delayed game launches in key Asian markets, a sharp rise in labour costs, and regulation of in-game item sales.

Nexon: PER bands (JPY) 1,800

1,500 27.4X 1,200 21.7X 900 10.4X 16.1X 600

300 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18

Source: Bloomberg, Company

Nexon: EV/EBITDA bands (JPY) 1,800 11.0X

1,500 8.9X

1,200 6.9X

900 4.8X 600 2.7X

300 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Source: Bloomberg, Company

Netmarble Games* 251270 KS Buy (1) 12.4 28.5 22.3 16.4 12.4 20.4 16.6 39.5 27.8 10.7 12.2 21.8 24.3 NCsoft* 036570 KS Buy (1) 7.6 16.6 11.9 8.7 6.1 12.1 18.6 15.8 39.1 17.1 19.9 36.7 41.2 Com2uS* 078340 KS O/P (2) 2.0 12.4 10.5 6.2 4.6 16.0 14.8 29.5 17.8 21.9 21.2 38.8 39.9 Kakao* 035720 KS Buy (1) 8.0 41.5 35.5 19.9 15.3 24.4 13.9 59.7 16.8 4.2 5.0 11.4 13.5 Pearl Abyss 263750 KS Not rated 2.5 13.6 9.2 9.8 5.5 N.A. 44.8 191.5 47.5 50.8 46.7 51.8 54.7 Korea average 22.5 17.9 12.2 8.8 18.2 21.7 67.2 29.8 20.9 21.0 32.1 34.7

Nexon* 3659 JP Buy (1) 13.4 14.3 13.7 8.5 6.9 18.5 7.7 80.0 4.7 19.3 17.0 42.8 44.2 Konami Holdings 9766 JP Buy (1) 7.0 20.1 18.9 9.2 8.4 9.7 3.6 20.0 6.6 14.1 13.5 21.0 21.7 Colopl 3668 JP Hold (3) 0.9 13.5 17.9 4.0 4.8 0.5 (7.4) (19.3) (24.6) 10.4 9.0 20.0 16.9 Square Enix 9684 JP O/P (2) 5.6 22.1 17.6 9.5 7.4 9.2 8.0 7.2 25.6 13.3 15.6 14.9 17.3 Mixi 2121 JP Hold (3) 2.0 6.7 7.4 1.2 1.3 (7.6) (9.2) (22.2) (9.5) 16.6 13.6 27.9 27.3 Cyberagent 4751 JP Buy (1) 7.2 105.8 58.8 17.5 14.5 13.1 11.5 87.5 80.1 9.5 15.3 8.2 9.0 Japan average-ex Nexon 33.7 24.1 8.3 7.3 5.0 1.3 14.6 15.6 12.8 13.4 18.4 18.5

Global average-ex Nexon 28.3 21.8 13.0 10.4 15.0 13.9 32.6 22.3 19.0 19.0 25.7 26.7

Source: *Daiwa forecasts, Bloomberg

Nexon (3659 JP): 11 July 2018

AI history and R&D capabilities

Milestones of AI initiatives Use of AI should help Nexon established its Intelligence Labs (IL) in April 2017 in order to deploy emerging AI Nexon in the long term technology for both new game development and marketing promotion. Previously, Nexon found it difficult to identify the key reasons for falling retention rates among its gamers. Without AI technology, it needed a large amount of human resources (developers, marketers, and even management) and time to identify the key factors, leading to weak demand for its live games.

Nexon: a brief history of the AI division Year Key events April 2017 Established IL 2018 Plans to increase the count of AI researchers to 300 by end-2018

Source: Company, Daiwa

Nexon, the leading game developer and publisher in Asia, successfully developed AI systems in 2017, helping it to analyse user profiles, gamers’ reviews, and overall transaction data. Using the AI system, the company has notably reduced the time and manpower needed to resolve the underlying problems of its core gaming operation. Nexon plans to expand the application scope of its AI system, whereby it will make use of AI technologies, and intends to increase the number of software developers for AI and related platforms from 60 as at end-4Q17 to 300 by end-2018.

Who leads the AI division at Nexon Nexon’s AI division has Dae-Hyun Kang, the Head of the IL division at Nexon, is now driving Nexon’s AI strategy. an experienced Mr Kang developed Crazy Arcade, one of Nexon’s well-known casual games. He also led executive at the helm the development project for DNF, the company’s flagship online game title.

Nexon: key individual of AI division Current title Head of Intelligence Labs, Nexon Korea Name Mr. Dae Hyun Kang Education Korea University, Seoul, Korea (Drop-out)

Work experience Joined Nexon in 2004 Started his career as a Director of ‘Crazy Arcade’, Nexon’s casual game

Key achievements Head of the development team of DNF at Neople Korea Head of Live Department, Nexon Korea

Vice President, Nexon Korea

Source: Company, compiled by Daiwa

At the Nexon Developers’ Conference in April 2018, Mr Kang emphasised that the company should find the ‘blind spots’ (undiscovered yet, but potentially very important factors in their longevity and viability) in its games, rather than relying on their past popularity. He believes Big Data can provide useful clues for finding blind spots, especially supported by AI technology and data analytic solutions. We expect Nexon to focus on transforming its valuable data assets into an evolving and scalable system using AI and other advanced technologies.

Mr Kang expects the application of AI analytics to Big Data for gaming services to help developers identify which factors and features could improve gamers’ experience through more appealing content. Nexon has a long-term strategy of using AI technology with a broader business scope while it continues to capitalise on its gaming base.

Owen Mahoney, the CEO of Nexon Japan, argues that the company will be able to operate all gaming services smoothly and efficiently if it uses the AI system to enhance in-game play and does not face any negative impact from inappropriate content updates or new game policies.

Nexon (3659 JP): 11 July 2018

AI journey is just the beginning We expect Nexon to use Nexon has 3 R&D laboratories under its main AI centre: 1) Analysis Centre, 2) AI technology on its Big Development Centre, and 3) TF Centre. Data base for a variety of applications Nexon’s Analysis Centre consists of: 1) a data analysis team (quantitative basis), and 2) a user interface (UX) analysis team (qualitative basis). The data analysis team tracks the user data of a specific or all games of Nexon, and shares any detected problems or abnormal patterns with the Development Centre, as well as the operations team for each game.

Nexon: organisational chart of AI centre

Source: Company, Daiwa

The Development Centre is divided into various teams: 1) service, 2) infrastructure, 3) fundamental technology, and 4) game system development. Each team manages the raw data to construct a data marketplace, and processes it to develop a service or a system that can be embedded into games. Through its use of AI technology, the company is keen to work on powerful automation solutions, which will leverage on its Big Data base and offer better solutions to related groups within Nexon. In addition, its development teams work on specific game engines, software modules, and utilities tools for each game.

At the TF Centre, software engineers carry out more basic but promising research, such as: 1) the detection of an abusive user, 2) the prevention of user churn, and 3) the detection of abnormal behaviour by gamers. At times, the Analysis and Development Centres works together on specific projects. Thereafter, the TF Centre incorporates the newly developed system or modules into each game after confirming the findings with the Development Centre.

Nexon (3659 JP): 11 July 2018

AI, games and business strategy

The first use case of AI in commercial games Nexon has used AI in Strategically, Nexon is keen to leverage on its Big Data base on gamers and gameplay Durango and FIFA Online using proven and powerful AI algorithms. By understanding gamers’ intentions in real time, 4 or with reference to a well-built dataset, the company believes that customised game content and better game experiences can reduce gamers’ churn, as well as lower operating costs for user acquisition and retention in the long term.

Nexon: key features of AI adoption Intelligence Labs Current Durango's virtual world environment is generated and customised according to players’ location and movement. FIFA Online 4 incorporates AI that controls multiple NPCs simultaneously for strategic game play mimicking real-world soccer. To be applied Life-like NPCs PvP matching based on machine learning technology

Problem detection using AI's analytics technology

Marketing event targeting an individual player

AI chat-bot that instructs the game rules to the users

Source: Company, compiled by Daiwa

Nexon commenced its Durango service in January 2018, a sandbox type mobile game that allows users to build their own empire while hunting and exploring the vast natural environment of a land populated by dinosaurs. In this game, the company has leveraged AI technology to react on a real-time basis depending on a gamer’s location and activity logs. Using deep learning technology, Durango provides gamers with greater opportunities to consume the “wildlife dungeons” of over 5m players.

In Durango, Nexon has used procedural content generation (PCG), which is the programmatic generation of game content using a random or pseudo-random process that results in an unpredictable range of possible game-play spaces. Durango immerses its players in a virtual fantasy world of great complexity automatically, based on random calculations by its AI algorithms, which produce in-game maps based on gamers’ access data and display virtual surroundings (like flowers and animals) according to the in-game ecosystem (climate, temperature and terrain).

Nexon: screenshot of Durango: Wild Lands

Source: Company, compiled by Daiwa

Meanwhile, in FIFA Online 4, the new version of Nexon’s online soccer game released in June 2018, the company incorporates a tactical system based on machine learning technology. The AI technology used in FIFA Online 4 helps improve play-assisted movements in attacking and defensive modes using AI-based programs.

Nexon (3659 JP): 11 July 2018

And in Sudden Attack, Nexon has used AI-based image processing technology to detect gamers’ abuse, and succeeded in monitoring and reducing overall counts of abuse. In particular, although the number of gamers’ abuse per minute grew by 14%, the number of gamers punished for abuse jumped to 97% of in-game abusive users, from 41%.

AI strategy and business initiatives Nexon has started using Nexon is focusing on tailoring and utilising AI technology to provide a virtual gaming customised AI environment in which gamers are offered more exciting and thrilling gameplay. The technology as an company uses AI-assisted pattern-recognition technology to analyse gamers’ behaviour indicator of game quality and experience for its game content. Its IL division is using over 10TB of gamers’ daily data (fun) (battle logs, user information, and traffic data) to add new game content to existing games as well as those being developed by its internal game-development studios.

Nexon has been using gamers’ retention, or churn, rate as a yardstick for game quality, to check whether a gamer enjoys the game or not, and to know if the gaming content is fun or not. Recently, the company has been carrying out a more detailed and interactive analysis of gamers’ behavioural patterns, reviews and in-game spending as its new indicator of game quality (fun). We think Nexon can capitalise on this AI-analysed data to further develop its strategy for game operation, monetisation, and new game development.

We think Nexon intends to pursue a more customised gameplay system, supported by advanced technology, which can identify user-specific factors that offer the user’s feedback on content, interface, gameplay, and even customer support. Nexon plans to leverage on AI technology to find and respond to the needs of all individual gamers in smarter ways.

Benefits of AI and business opportunity The key aim of Nexon’s Nexon adopted machine learning (ML) technology to offer an optimal match-making AI systems is to improve feature, behaviour pattern-recognition technology to detect abnormal plays, and video and gamers’ experience image recognition technology to detect in-game abusive users. In addition, Nexon is working on a development project, active adviser, to operate as an intelligent agent for guiding gameplay for mobile gamers.

The primary goal of Nexon’s AI systems is to enhance gamers’ experience using more dynamic matching algorithms, based on gamers’ skillset, different assets, and current states. Also, using an AI-supported recognition system for motion and images, the company can help gamers play without any unfair gameplay created by auto-playing characters or “gold miners” within a game’s ecosystem.

Separately, Nexon is in the process of creating an analytics service for game publishers and providing a live API as a platform for machine learning. We view this strategic move as another one of the company’s efforts to build the best gaming environment for its users. Management believes the company will be able to fully capitalise on AI and other related technologies given its extensive database accrued from a business history of more than 20 years.

In our view, Nexon will focus only on the gaming industry while seeking many proprietary AI technologies from the ICT industry. The implication is that the company will select only those AI technologies that are applicable to its gaming services. Ultimately, we think Nexon targets to develop an interactive and intelligent game that will utilise AI technology to interact and play like a human gamer.

Nexon (3659 JP): 11 July 2018

Earnings outlook

Core online games set to boost earnings over 2018-20E We see solid and visible We expect Nexon’s revenue and earnings growth over 2018-20 to be driven by: 1) the momentum for the core launches of strong IP-based games, 2) robust game sales of existing titles, and 3) business over 2018-20E expansion of Nexon’s service regions. We look for Nexon to enter a robust earnings growth cycle from 2H18, led by the rollout of content update offerings for DNF and Maple Story in China and Korea, respectively, and the global launch of FIFA 4.

Nexon plans to launch 8 new games in Korea over 2H18-2019. It intends to focus on RPGs rather than casual and strategic games, as RPGs tend to have higher ARPUs and longer service cycles. Among the games in pipeline from 2H18, management has high expectations of big mobile RPGs like DNF, Durango and Overhit globally.

Nexon: new games to be launched over 2018-19 Genre Developer details and description Korea

Yulgang M (launched 01/11/18) RPG Story line based on Korea's famous heroic comic books, Developed by Act5 Moonlight Blade Online (launched 01/25/18) MMORPG Developed by Tencent Durango: Wild Lands (launched 01/25/18) MMORPG Developed by Nexon What Studio, Made into MBC program "Dunia" which is an unreal variety TV show FIFA online 4 (launched 05/17/18) Casual Sports Popular soccer game, Released one month before the World Cup 2018, Developed by Spearhead Kaiser (launched 06/07/18) MMORPG Rated R game, Developed by Pathfinder8 FIFA online 4 M Casual Sports Mobile version of FIFA Online 4 Astellia Online MMORPG Battle game, Developed by Studio 8 Battlerite Online AOS Battle game, Developed by Stunlock Studio Mabinogi Mobile RPG Battle game, Developed by Nexon and devCAT Studio Nova Wars STG Mobile SF galaxy battle strategy game, Developed by ESTgames Ascendant One MOBA Online 5 vs 5 multiplayer battle arena game, Developed by devCAT Studio Magia Action RPG Mobile 2D side-scroll action RPG, Developed by Super Acid Project DH Online Action RPG Dragon action battle game, Developed by devCAT Studio Dawn Fall Tactic RPG Monster battle and adventure, Developed by Nexon Overseas Overhit (launched 05/29/18 in Japan) Collection RPG Targets global markets, Developed by Nexon Maple Blitz X (launched 02/28/18 in Korea and SEA) RPG Released in South-East Asia and Korea at the same date, Developed by Nexon Durango: Wild Lands (launched 05/07/18 in Indonesia) MMORPG Targets global market with the global version, Developed by Nexon What Studio Hexia (launched 05/16/18 in Japan) Tactical RPG Targets Japan, Developed by Gloop, a subsidiary of Nexon Marvel Battlelines MMORPG Mobile card game, Developed by devCAT Studio Maple Story M MMORPG Targets North America, Developed by Nexon Magia Action RPG Mobile 2D side-scroll action RPG, Developed by Super Acid Maple Story 2 MMORPG Targets China and North America, CBT started on 05/09/18, Developed by Nexon Darkness Rises Action RPG Targets North America and global market with 13 different languages, Developed by Nexon Final Fantasy 11 mobile MMORPG Targets Asia (including Japan), North America and Europe, Unreal engine 4, Developed by Nexon Gigant Shock RPG Targets Japan, Pre-reservation started on 5/31/18, Developed by Carbon Eyed Dungeon & Fighter 2D mobile MMORPG Targets China, Developed by Nexon AxE MMORPG Targets North America, Developed by Nexon Red

Source: Company, compiled by Daiwa. Shaded games are slated to be released in 2H18.

We forecast Nexon’s revenue to see a CAGR of 10% over 2017-20, with mobile game revenue contributing 29-44% of total revenue over the period. Meanwhile, we expect Nexon to record an operating-profit margin of 42.8-45.3% over 2018-20, and spend 6-9% of its total revenue on marketing as it plans to ramp up global expansion, boost gamer traffic in Asia, and retain loyal players in Korea. Assuming a marginal increase in its headcount for the core game-development studios, we expect its cost structure to stabilise over our forecast horizon.

On our forecasts, Nexon’s EPS will see a CAGR of 25% over 2017-20 due to the expected solid growth in revenue from Nexon’s online and mobile blockbuster games over 2018-19, a potential sharp rise in overseas royalty revenue, and a disciplined cost strategy for marketing and sales commissions.

Nexon (3659 JP): 11 July 2018

Nexon: revenue mix and profitability (JPYbn) 350 50 45 300 40 250 35 200 30 25 150 20 100 15 10 50 5 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018E 2019E 2020E Korea China North America Others Japan OPM (%, RHS)

Source: Company, Daiwa forecasts

2Q18 preview: operating profit to decline on higher marketing costs We forecast 2Q18 Management guides for 2Q18 revenue growth of -4% YoY to +4% YoY and an operating- revenue to grow by 8.6% profit decline of 17-36% YoY, resulting in an operating-profit margin of 23-28% vs. 35% in YoY and operating profit 2Q17. The company attributes the lower profitability for 2Q18E to a combination of higher to decline by 5.4% YoY labour costs and the ramp-up in marketing expenditure for FIFA Online 4, Overhit, and Kaiser. Nexon continues to expect a positive impact on its revenue and earnings from the DNF game in China, which is seeing ongoing content updates (the Labor Day update in April 2018 and 10th Anniversary Update in June 2018).

We believe Nexon will achieve its revenue and earnings targets for 2018 without difficulty, given the solid seasonal demand for online game content globally that we saw during the year-end season in 2017. We expect Nexon’s established channels for game publishing to support robust top-line growth in 2018, supported by a concrete line-up of proven games. We forecast Nexon’s revenue to grow by 8.6% YoY and operating profit to fall by 5.4% YoY in 2Q18, on the back of a high base in 2017 due to its success in China.

Nexon: quarterly earnings trends (3Q16-2Q18E) (JPYbn) 2Q18E

3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 Daiwa Consensus

Revenue 44.3 43.3 74.8 47.1 60.4 52.7 90.5 51.2 51.0 YoY growth (%) (11.2) (5.6) 30.1 23.5 36.5 21.8 21.0 8.6 8.3 QoQ growth (%) 16.1 (2.3) 72.9 (37.0) 28.2 (12.8) 71.8 (43.5) (43.6) Operating profit 16.3 7.3 39.8 16.3 22.7 11.8 54.7 15.4 16.8 YoY growth (%) (11.6) (29.4) 973.8 21.7 39.4 61.4 37.6 (5.4) 3.0 QoQ growth (%) 21.8 (55.3) 445.7 (59.1) 39.5 (48.2) 365.4 (71.9) (69.4) OP margin (%) 36.8 16.8 53.2 34.6 37.6 22.3 60.5 30.1 32.9

Source: Company, Daiwa forecast

Earnings forecast revisions We expect rising labour Thanks to strong game content for local users, we expect Overhit to generate robust costs to be a drag on revenue from Japan in 4Q18, while the company continues to focus on niche gamers earnings over 2018-20 through Kaiser, which features in-game item commerce (Korea), and Durango, an open- field RPG, internationally. We forecast Nexon’s 2018 revenue to grow by 18.5% YoY to JPY278bn and its operating-profit margin to widen to 42.8% (vs. 38.5% in 2017). We lower our 2018-20E EPS by 1.2-4.4% to factor in our assumptions of an increase in headcount, higher labour costs for new game development, and higher salaries in Korea.

Nexon: earnings forecast revisions (JPYbn) Previous New Revision (%) 2018E 2019E 2020E 2018E 2019E 2020E 2018E 2019E 2020E

Revenue 278.3 298.2 309.4 278.3 299.6 311.8 (0.0) 0.5 0.8 Operating profit 121.4 131.6 139.3 119.2 132.4 141.1 (1.8) 0.6 1.3 Net profit 107.9 111.3 115.0 103.4 108.9 114.0 (4.2) (2.2) (0.9) EPS 122.0 125.4 129.5 117.0 122.2 127.9 (4.4) (2.5) (1.2)

Source: Company, Daiwa forecasts

Nexon (3659 JP): 11 July 2018

Daiwa’s Asia Pacific Research Directory

HONG KONG SOUTH KOREA Takashi FUJIKURA (852) 2848 4051 [email protected] Sung Yop CHUNG (82) 2 787 9157 [email protected] Regional Research Head Pan-Asia Co-head/Regional Head of Automobiles and Components; Automobiles; Jiro IOKIBE (852) 2773 8702 [email protected] Shipbuilding; Steel Co-head of Asia Pacific Research Mike OH (82) 2 787 9179 [email protected] John HETHERINGTON (852) 2773 8787 [email protected] Banking; Capital Goods (Construction and Machinery) Co-head of Asia Pacific Research Josh RHEE (82) 2 787 9124 [email protected] Craig CORK (852) 2848 4463 [email protected] Chemicals Regional Head of Asia Pacific Product Management Iris PARK (82) 2 787 9165 [email protected] Paul M. KITNEY (852) 2848 4947 [email protected] Consumer/Retail Chief Strategist for Asia Pacific; Strategy (Regional) SK KIM (82) 2 787 9173 [email protected] Kevin LAI (852) 2848 4926 [email protected] IT/Electronics – Semiconductor/Display and Tech Hardware Chief Economist for Asia ex-Japan; Macro Economics (Regional) Thomas Y KWON (82) 2 787 9181 [email protected] Olivia XIA (852) 2773 8736 [email protected] Pan-Asia Head of Internet & Telecommunications; Software – Internet/On-line Games Macro Economics (Regional/China) Kelvin LAU (852) 2848 4467 [email protected] TAIWAN Head of Automobiles; Transportation and Industrial (Hong Kong/China) Rick HSU (886) 2 8758 6261 [email protected] Jay LU (852) 2848 4970 [email protected] Head of Regional Technology; Head of Taiwan Research; Semiconductor/IC Design (Regional) Automobiles and Components (Hong Kong/China) Nora HOU (886) 2 8758 6249 [email protected] Leon QI (852) 2532 4381 [email protected] Banking; Diversified financials; Insurance Regional Head of Financials; Banking; Diversified financials; Insurance (Hong Kong/China) Steven TSENG (886) 2 8758 6252 [email protected] Anson CHAN (852) 2532 4350 [email protected] IT/Technology Hardware (Automation & PC Hardware) Kylie HUANG (886) 2 8758 6248 [email protected] Consumer (Hong Kong/China) Adrian CHAN (852) 2848 4427 [email protected] IT/Technology Hardware (Handsets and Components) Consumer (Hong Kong/China) Helen CHIEN (886) 2 8758 6254 [email protected] John CHOI (852) 2773 8730 [email protected] Small/Mid Cap Head of Hong Kong and China Internet; Regional Head of Small/Mid Cap Fiona LIANG (852) 2532 4341 [email protected] INDIA Punit SRIVASTAVA (91) 22 6622 1013 [email protected] Industrial (Hong Kong/China) Dennis IP (852) 2848 4068 [email protected] Head of India Research; Strategy; Banking/Finance Saurabh MEHTA (91) 22 6622 1009 [email protected] Regional Head of Power, Utilities, Renewable and Environment (PURE); PURE (Hong Kong/China) Capital Goods; Utilities Daniel YANG (852) 2848 4443 [email protected] Power, Utilities, Renewable and Environment (PURE) – Solar and Nuclear (China) SINGAPORE Don LAU (852) 2848 4469 [email protected] Ramakrishna MARUVADA (65) 6228 6742 [email protected] Power, Utilities, Renewable and Environment (PURE) – Utilities (Hong Kong) Head of Singapore Research; Telecommunications (China/ASEAN/India) Jonas KAN (852) 2848 4439 [email protected] David LUM (65) 6228 6740 [email protected] Head of Hong Kong and China Property Banking; Property and REITs Cynthia CHAN (852) 2773 8243 [email protected] Royston TAN (65) 6228 6745 [email protected] Property (China) Oil and Gas; Capital Goods Carlton LAI (852) 2532 4349 [email protected] Jame OSMAN (65) 6228 6744 [email protected] Small/Mid Cap (Hong Kong/China) Transportation – Road and Rail; Pharmaceuticals and Healthcare; Consumer (Singapore) Michelle WANG (852) 2773 8842 [email protected] Transportation (Hong Kong/China) JAPAN Selwyn CHENG (852) 2773 8716 [email protected] Yukino YAMADA (81) 3 5555 7295 [email protected] Strategy (Regional) Custom Products Group

PHILIPPINES Renzo CANDANO (63) 2 737 3022 [email protected] Consumer Micaela ABAQUITA (63) 2 737 3021 [email protected] Property Gregg ILAG (63) 2 737 3023 [email protected] Utilities; Energy

Nexon (3659 JP): 11 July 2018

Daiwa’s Offices Office / Branch / Affiliate Address Tel Fax DAIWA SECURITIES GROUP INC HEAD OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6753 (81) 3 5555 3111 (81) 3 5555 0661 Daiwa Securities Trust Company One Evertrust Plaza, Jersey City, NJ 07302, U.S.A. (1) 201 333 7300 (1) 201 333 7726 Daiwa Securities Trust and Banking (Europe) PLC (Head Office) 5 King William Street, London EC4N 7JB, United Kingdom (44) 207 320 8000 (44) 207 410 0129 Daiwa Europe Trustees (Ireland) Ltd Level 3, Block 5, Harcourt Centre, Harcourt Road, Dublin 2, Ireland (353) 1 603 9900 (353) 1 478 3469

Daiwa Capital Markets America Inc. New York Head Office Financial Square, 32 Old Slip, New York, NY10005, U.S.A. (1) 212 612 7000 (1) 212 612 7100 Daiwa Capital Markets America Inc. San Francisco Branch 555 California Street, Suite 3360, San Francisco, CA 94104, U.S.A. (1) 415 955 8100 (1) 415 956 1935 Daiwa Capital Markets Europe Limited, London Head Office 5 King William Street, London EC4N 7AX, United Kingdom (44) 20 7597 8000 (44) 20 7597 8600 Daiwa Capital Markets Europe Limited, Frankfurt Branch Neue Mainzer Str. 1, 60311 Frankfurt/Main, Germany (49) 69 717 080 (49) 69 723 340 Daiwa Capital Markets Europe Limited, Paris Representative Office 17, rue de Surène 75008 Paris, France (33) 1 56 262 200 (33) 1 47 550 808 Daiwa Capital Markets Europe Limited, Geneva Branch 50 rue du Rhône, P.O.Box 3198, 1211 Geneva 3, Switzerland (41) 22 818 7400 (41) 22 818 7441 Daiwa Capital Markets Europe Limited, Midland Plaza 7th Floor, 10 Arbat Street, Moscow 119002, (7) 495 641 3416 (7) 495 775 6238 Moscow Representative Office Russian Federation Daiwa Capital Markets Europe Limited, Bahrain Branch 7th Floor, The Tower, Bahrain Commercial Complex, P.O. Box 30069, (973) 17 534 452 (973) 17 535 113 Manama, Bahrain Daiwa Capital Markets Hong Kong Limited Level 28, One Pacific Place, 88 Queensway, Hong Kong (852) 2525 0121 (852) 2845 1621 Daiwa Capital Markets Singapore Limited 7 Straits View, Marina One East Tower, #16-05 & #16-06, (65) 6387 8888 (65) 6282 8030 Singapore 018936, Republic of Singapore Daiwa Capital Markets Australia Limited Level 34, Rialto North Tower, 525 Collins Street, Melbourne, (61) 3 9916 1300 (61) 3 9916 1330 Victoria 3000, Australia DBP-Daiwa Capital Markets Philippines, Inc 18th Floor, Citibank Tower, 8741 Paseo de Roxas, Salcedo Village, (632) 813 7344 (632) 848 0105 Makati City, Republic of the Philippines Daiwa-Cathay Capital Markets Co Ltd 14/F, 200, Keelung Road, Sec 1, Taipei, Taiwan, R.O.C. (886) 2 2723 9698 (886) 2 2345 3638 Daiwa Securities Capital Markets Korea Co., Ltd. 20 Fl.& 21Fl. One IFC, 10 Gukjegeumyung-Ro, Yeongdeungpo-gu, (82) 2 787 9100 (82) 2 787 9191 Seoul, Korea Daiwa Securities Co. Ltd., Beijing Representative Office Room 301/302，Kerry Center，1 Guanghua Road，Chaoyang District， (86) 10 6500 6688 (86) 10 6500 3594 Beijing 100020, People’s Republic of China Daiwa (Shanghai) Corporate Strategic Advisory Co. Ltd. 44/F, Hang Seng Bank Tower, 1000 Lujiazui Ring Road, Pudong, (86) 21 3858 2000 (86) 21 3858 2111 Shanghai China 200120 , People’s Republic of China Daiwa Securities Co. Ltd., Bangkok Representative Office 18th Floor, M Thai Tower, All Seasons Place, 87 Wireless Road, (66) 2 252 5650 (66) 2 252 5665 Lumpini, Pathumwan, Bangkok 10330, Thailand Daiwa Capital Markets India Private Ltd 10th Floor, 3 North Avenue, Maker Maxity, Bandra Kurla Complex, (91) 22 6622 1000 (91) 22 6622 1019 Bandra East, Mumbai – 400051, India Daiwa Securities Co. Ltd., Hanoi Representative Office Suite 405, Pacific Palace Building, 83B, Ly Thuong Kiet Street, (84) 4 3946 0460 (84) 4 3946 0461 Hoan Kiem Dist. Hanoi, Vietnam

DAIWA INSTITUTE OF RESEARCH LTD HEAD OFFICE 15-6, Fuyuki, Koto-ku, Tokyo, 135-8460, Japan (81) 3 5620 5100 (81) 3 5620 5603 MARUNOUCHI OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6756 (81) 3 5555 7011 (81) 3 5202 2021

New York Research Center 11th Floor, Financial Square, 32 Old Slip, NY, NY 10005-3504, U.S.A. (1) 212 612 6100 (1) 212 612 8417 London Research Centre 3/F, 5 King William Street, London, EC4N 7AX, United Kingdom (44) 207 597 8000 (44) 207 597 8550

Nexon (3659 JP): 11 July 2018

NCsoft: share price and Daiwa recommendation trend Date Target Price Rating Date Target price Rating Date Target price Rating 11/02/16 278,000 Buy 07/02/17 350,000 Buy 07/02/18 520,000 Buy 13/05/16 285,000 Buy 20/07/17 430,000 Buy 10/05/18 470,000 Buy 11/08/16 295,000 Buy 07/08/17 450,000 Buy

10/11/16 317,000 Buy 23/11/17 550,000 Buy 550,000 550,000 520,000 500,000 470,000 450,000 450,000 430,000 400,000

350,000 350,000 317,000 300,000 295,000 278,000 285,000 250,000 245,000 243,000

200,000

150,000

Jul-15 Jul-16 Jul-17 Jul-18

Oct-15 Apr-16 Oct-16 Apr-17 Oct-17 Apr-18

Jan-16 Jun-16 Jan-17 Jun-17 Jan-18 Jun-18

Feb-17 Feb-16 Mar-16 Mar-17 Feb-18 Mar-18

Aug-15 Sep-17 Sep-15 Nov-15 Dec-15 Aug-16 Sep-16 Nov-16 Dec-16 Aug-17 Nov-17 Dec-17

May-16 May-17 May-18

Target price (KRW) Closing Price (KRW)

Source: Daiwa Note: where appropriate, historical target prices have been adjusted to reflect the current share count

Netmarble Games: share price and Daiwa recommendation trend Date Target Price Rating Date Target price Rating Date Target price Rating 08/06/17 175,000 Outperform 07/11/17 200,000 Outperform 30/04/18 171,000 Buy

11/08/17 143,000 Outperform 06/02/18 175,000 Outperform 200,000 200,000

190,000

180,000 175,000 175,000 170,000 171,000

160,000

150,000 143,000 140,000

130,000

120,000

Jul-17 Jul-17 Jul-18

Oct-17 Oct-17 Apr-18 Apr-18

Jun-17 Jun-17 Jan-18 Jan-18 Jun-18 Jun-18

Feb-18 Feb-18 Mar-18 Mar-18 Mar-18

Aug-17 Aug-17 Sep-17 Sep-17 Sep-17 Nov-17 Nov-17 Dec-17 Dec-17

May-18 May-17 May-17 May-18

Target price (KRW) Closing Price (KRW)

Source: Daiwa Note: where appropriate, historical target prices have been adjusted to reflect the current share count

Nexon (3659 JP): 11 July 2018

Important Disclosures and Disclaimer

This publication is produced by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, and distributed by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, except to the extent expressly provided herein. This publication and the contents hereof are intended for information purposes only, and may be subject to change without further notice. Any use, disclosure, distribution, dissemination, copying, printing or reliance on this publication for any other purpose without our prior consent or approval is strictly prohibited. Neither Daiwa Securities Group Inc. nor any of its respective parent, holding, subsidiaries or affiliates, nor any of its respective directors, officers, servants and employees, represent nor warrant the accuracy or completeness of the information contained herein or as to the existence of other facts which might be significant, and will not accept any responsibility or liability whatsoever for any use of or reliance upon this publication or any of the contents hereof. Neither this publication, nor any content hereof, constitute, or are to be construed as, an offer or solicitation of an offer to buy or sell any of the securities or investments mentioned herein in any country or jurisdiction nor, unless expressly provided, any recommendation or investment opinion or advice. Any view, recommendation, opinion or advice expressed in this publication may not necessarily reflect those of Daiwa Securities Group Inc., and/or its affiliates nor any of its respective directors, officers, servants and employees except where the publication states otherwise. This research report is not to be relied upon by any person in making any investment decision or otherwise advising with respect to, or dealing in, the securities mentioned, as it does not take into account the specific investment objectives, financial situation and particular needs of any person. Daiwa Securities Group Inc., its subsidiaries or affiliates, or its or their respective directors, officers and employees from time to time have trades as principals, or have positions in, or have other interests in the securities of the company under research including market making activities, derivatives in respect of such securities or may have also performed investment banking and other services for the issuer of such securities. Daiwa Securities Group Inc., its subsidiaries or affiliates do and seek to do business with the company(s) covered in this research report. Therefore, investors should be aware that a conflict of interest may exist. The following are additional disclosures.

Ownership of Securities For “Ownership of Securities” information, please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationship For “Investment Banking Relationship”, please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

Japan Daiwa Securities Co. Ltd. and Daiwa Securities Group Inc. Daiwa Securities Co. Ltd. is a subsidiary of Daiwa Securities Group Inc. Investment Banking Relationship Within the preceding 12 months, the subsidiaries and/or affiliates of Daiwa Securities Group Inc. * has lead-managed public offerings and/or secondary offerings (excluding straight bonds) of the securities of the following companies: Cromwell European REIT (CERT_SP), Beijing Enterprises Water Group Ltd (371 HK), Mirae Asset Daewoo Co Ltd (006800 KS).

*Subsidiaries of Daiwa Securities Group Inc. for the purposes of this section shall mean any one or more of: Daiwa Capital Markets Hong Kong Limited (大和資本市場香港有限公司), Daiwa Capital Markets Singapore Limited, Daiwa Capital Markets Australia Limited, Daiwa Capital Markets India Private Limited, Daiwa-Cathay Capital Markets Co., Ltd., Daiwa Securities Capital Markets Korea Co., Ltd.

Hong Kong This research is distributed in Hong Kong by Daiwa Capital Markets Hong Kong Limited (大和資本市場香港有限公司) (“DHK”) which is regulated by the Hong Kong Securities and Futures Commission. Recipients of this research in Hong Kong may contact DHK in respect of any matter arising from or in connection with this research.

Relevant Relationship (DHK) DHK may from time to time have an individual employed by or associated with it serves as an officer of any of the companies under its research coverage.

Korea The developing analyst of this research and analysis material hereby states and confirms that the contents of this material correctly reflect the analyst’s views and opinions and that the analyst has not been placed under inappropriate pressure or interruption by an external party.

Name of Analyst : Thomas Y Kwon

Disclosure of Analysts’ Interests If an analyst engaging in or a person who exercises influences on the preparation or publication of a Research Report containing recommendations for general investors to trade financial investment instruments with regard to which the analyst or the influential person has personal interests and if the recommendations contained in the Report may have impacts on the personal interests, Daiwa Securities Capital Markets Korea Co., Ltd.(“Daiwa Securities Korea”)shall ensure that the Analyst or the influential person notifies that he/she has personal interests with regard to:

1. The equity, the equity-linked bonds and the instruments with the subscription right to the equity issued by the legal entity covered in the Research Report (or the legal entity subject to the investment recommendations); 2. The stock option granted by the legal entity covered in the Research Report (or the legal entity subject to the investment recommendations); or 3. The equity futures, the equity options and the equity-linked warrants backed by the equity prescribed in the preceding Paragraph 1 as the underlying assets.

Legal Entities subject to Research Report Coverage Restrictions Daiwa Securities Korea hereby states and confirms that Daiwa Securities Korea has no conflicts of interests with the legal entity covered in this Research Report:

1. In that Daiwa Securities Korea does NOT offer direct or indirect payment guarantee for the legal entity by means of, for instance, guarantee, endorsement, provision of collaterals or the acquisition of debts; 2. In that Daiwa Securities Korea does NOT own one-hundredth (or 1/100) or more of the total number of outstanding equities issued by the legal entity; 3. In that The legal entity is NOT an affiliated company of Daiwa Securities Korea pursuant to Sub-paragraph 3, Article 2 of the Monopoly Regulation and Fair Trade Act of Korea; 4. In that, although Daiwa Securities Korea offers advisory services for the legal entity with regard to an M&A deal, the size of the M&A deal does NOT exceed five-hundredths (or 5/100) of the total asset size or the total number of equities issued and outstanding of the legal entity; 5. In that, although Daiwa Securities Korea acted in the capacity of a Lead Underwriter for the initial public offering of the legal entity, more than one-year has passed since the IPO date; 6. In that Daiwa Securities Korea is NOT designated by the legal entity as the ‘tender offer agent’ pursuant to the Paragraph 2, Article 133 of the Financial Services and Capital Market Act or the legal entity is NOT the issuer of the equity subject to the proposed tender offer; this requirement, however applies until the maturity of the tender offer period; or 7. In that Daiwa Securities Korea does NOT have significant or material interests with regard to the legal entity.

Disclosure of Prior Distribution to Third Party This report has not been distributed to the third party in advance prior to public release.

The following explains the rating system in the report as compared to KOSPI, based on the beliefs of the author(s) of this report.

"1": the security could outperform the KOSPI by more than 15% over the next 12 months, unless otherwise stated. "2": the security is expected to outperform the KOSPI by 5-15% over the next 12 months, unless otherwise stated. "3": the security is expected to perform within 5% of the KOSPI (better or worse) over the next 12 months, unless otherwise stated. "4": the security is expected to underperform the KOSPI by 5-15% over the next 12 months, unless otherwise stated. "5": the security could underperform the KOSPI by more than 15% over the next 12 months, unless otherwise stated.

“Positive” means that the analyst expects the sector to outperform the KOSPI over the next 12 months, unless otherwise stated. “Neutral” means that the analyst expects the sector to be in-line with the KOSPI over the next 12 months, unless otherwise stated. “Negative” means that the analyst expects the sector to underperform the KOSPI over the next 12 months, unless otherwise stated.

Additional information may be available upon request.

Singapore This research is distributed in Singapore by Daiwa Capital Markets Singapore Limited and it may only be distributed in Singapore to accredited investors, expert investors and institutional investors as defined in the Financial Advisers Regulations and the Securities and Futures Act (Chapter 289), as amended from time to time. By virtue of distribution to these category of investors, Daiwa Capital Markets Singapore Limited and its representatives are not required to comply with Section 36 of the Financial Advisers Act (Chapter 110) (Section 36 relates to disclosure of Daiwa Capital Markets Singapore Limited’s interest and/or its representative’s interest in securities). Recipients of this research in Singapore may contact Daiwa Capital Markets Singapore Limited in respect of any matter arising from or in connection with the research.

Australia This research is distributed in Australia by Daiwa Capital Markets Australia Limited and it may only be distributed in Australia to wholesale investors within the meaning of the Corporations Act. Recipients of this research in Australia may contact Daiwa Capital Markets Stockbroking Limited in respect of any matter arising from or in connection with the research.

Nexon (3659 JP): 11 July 2018

India This research is distributed in India to Institutional Clients only by Daiwa Capital Markets India Private Limited (Daiwa India) which is an intermediary registered with Securities & Exchange Board of India as a Stock Broker, Merchant Bank and Research Analyst. Daiwa India, its Research Analyst and their family members and its associates do not have any financial interest save as disclosed or other undisclosed material conflict of interest in the securities or derivatives of any companies under coverage. Daiwa India and its associates, may have received compensation for any products other than Investment Banking (as disclosed)or brokerage services from the subject company in this report or from any third party during the past 12 months. Daiwa India and its associates may have debt holdings in the subject company. For information on ownership of equity, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. There is no material disciplinary action against Daiwa India by any regulatory authority impacting equity research analysis activities as of the date of this report. Associates of Daiwa India, registered with Indian regulators, include Daiwa Capital Markets Singapore Limited and Daiwa Portfolio Advisory (India) Private Limited.

Taiwan This research is solely for reference and not intended to provide tailored investment recommendations. This research is distributed in Taiwan by Daiwa-Cathay Capital Markets Co., Ltd. and it may only be distributed in Taiwan to specific customers who have signed recommendation contracts with Daiwa-Cathay Capital Markets Co., Ltd. and non-customers including (i) professional institutional investors, (ii) TWSE or TPEx listed companies, upstream and downstream vendors, and specialists that offer or seek advice, and (iii) potential customers with an actual need for business development in accordance with the Operational Regulations Governing Securities Firms Recommending Trades in Securities to Customers. Recipients of this research including non-customer recipients of this research shall not provide it to others or engage in any activities in connection with this research which may involve conflicts of interests. Neither Daiwa-Cathay Capital Markets Co., Ltd. nor its personnel who writes or reviews the research report has any conflict of interest in this research. Since Daiwa-Cathay Capital Markets Co., Ltd. does not operate brokerage trading business in foreign markets, this research is prepared on a “without recommendation” to any foreign securities basis and Daiwa-Cathay Capital Markets Co., Ltd. does not accept orders from customers to trade in such foreign securities that are without recommendation. Recipients of this research in Taiwan may contact Daiwa-Cathay Capital Markets Co., Ltd. in respect of any matter arising from or in connection with the research.

Philippines This research is distributed in the Philippines by DBP-Daiwa Capital Markets Philippines, Inc. which is regulated by the Philippines Securities and Exchange Commission and the Philippines Stock Exchange, Inc. Recipients of this research in the Philippines may contact DBP-Daiwa Capital Markets Philippines, Inc. in respect of any matter arising from or in connection with the research. DBP-Daiwa Capital Markets Philippines, Inc. recommends that investors independently assess, with a professional advisor, the specific financial risks as well as the legal, regulatory, tax, accounting, and other consequences of a proposed transaction. DBP-Daiwa Capital Markets Philippines, Inc. may have positions or may be materially interested in the securities in any of the markets mentioned in the publication or may have performed other services for the issuers of such securities. For relevant securities and trading rules please visit SEC and PSE links at http://www.sec.gov.ph and http://www.pse.com.ph/ respectively.

Thailand This research is distributed to only institutional investors in Thailand primarily by Thanachart Securities Public Company Limited (“TNS”). This report is prepared by analysts who are employed by Daiwa Securities Group Inc. and/or its non-U.S. affiliates. This report is provided to you for informational purposes only and it is not, and is not to be construed as, an offer or an invitation to make an offer to sell or buy any securities. Neither TNS, Daiwa Securities Group Inc. nor any of their respective parent, holding, subsidiaries or affiliates, nor any of their respective directors, officers, servants and employees accept any liability whatsoever for any direct or consequential loss arising from any use of this research or its contents. The information and opinions contained herein have been compiled or arrived at from sources believed to be reliable. However, TNS, Daiwa Securities Group Inc. nor any of their respective parent, holding, subsidiaries or affiliates, nor any of their respective directors, officers, servants and employees make no representation or warranty, express or implied, as to their accuracy or completeness. Expressions of opinion herein are subject to change without notice. The use of any information, forecasts and opinions contained in this report shall be at the sole discretion and risk of the user. TNS, Daiwa Securities Group Inc., their respective parent, holding, subsidiaries or affiliates, their respective directors, officers, servants and employees may have positions and financial interest in securities mentioned in this research. Thanachart Securities Public Company Limited, Daiwa Securities Group Inc., their respective parent, holding, subsidiaries or affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this research. Therefore, investors should be aware of conflict of interest that may affect the objectivity of this research.

United Kingdom This research report is produced by Daiwa Securities Co. Ltd. and/or its affiliates and is distributed in the European Union, Iceland, Liechtenstein, Norway and Switzerland. Daiwa Capital Markets Europe Limited is authorised and regulated by The Financial Conduct Authority (“FCA”) and is a member of the London Stock Exchange and Eurex. This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FCA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-regulatory.

Germany This document is distributed in Germany by Daiwa Capital Markets Europe Limited, Niederlassung Frankfurt which is regulated by BaFin (Bundesanstalt fuer Finanzdienstleistungsaufsicht) for the conduct of business in Germany.

Bahrain This research material is distributed in Bahrain by Daiwa Capital Markets Europe Limited, Bahrain Branch, regulated by The Central Bank of Bahrain and holds Investment Business Firm – Category 2 license and having its official place of business at the Bahrain World Trade Centre, South Tower, 7th floor, P.O. Box 30069, Manama, Kingdom of Bahrain. Tel No. +973 17534452 Fax No. +973 535113

United States This research is distributed into the United States directly by Daiwa Capital Markets Hong Kong Limited and indirectly by Daiwa Capital Markets America Inc. (DCMA), a U.S. Securities and Exchange Commission registered broker-dealer and FINRA member firm, exclusively to “major U.S. institutional investors”, as defined under Rule 15a-6 promulgated under the U.S. Securities Exchange Act of 1934, as amended, and as interpreted by the staff of the U.S. Securities and Exchange Commission (SEC). This report is not an offer to sell or the solicitation of any offer to buy securities. U.S. customers wishing to effect transactions in any designated investment discussed in this report should do so through a qualified salesperson of DCMA. Non-U.S. customers wishing to effect transactions in any designated investment discussed in this report should contact a Daiwa entity in their local jurisdiction. The securities or other investment products discussed in this report may not be eligible for sale in some jurisdictions. Analysts employed outside the U.S., as specifically indicated elsewhere in this report, are not registered as research analysts with FINRA. These analysts may not be associated persons of DCMA, and therefore may not be subject to FINRA Rule 2241 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. ADDITIONAL IMPORTANT DISCLOSURES CAN BE FOUND AT: https://daiwa3.bluematrix.com/sellside/Disclosures.action

Ownership of Securities For “Ownership of Securities” information please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationships For “Investment Banking Relationships” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. DCMA Market Making For “DCMA Market Making” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

Research Analyst Conflicts For updates on “Research Analyst Conflicts” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The principal research analysts who prepared this report have no financial interest in securities of the issuers covered in the report, are not (nor are any members of their household) an officer, director or advisory board member of the issuer(s) covered in the report, and are not aware of any material relevant conflict of interest involving the analyst or DCMA, and did not receive any compensation from the issuer during the past 12 months except as noted: no exceptions.

Research Analyst Certification For updates on “Research Analyst Certification” and “Rating System” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analyst is named on the report); and no part of the compensation of such analyst (or no part of the compensation of the firm if no individual analyst is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report.

The following explains the rating system in the report as compared to relevant local indices, unless otherwise stated, based on the beliefs of the author of the report.

Nexon (3659 JP): 11 July 2018

"1": the security could outperform the local index by more than 15% over the next 12 months. "2": the security is expected to outperform the local index by 5-15% over the next 12 months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next 12 months. "4": the security is expected to underperform the local index by 5-15% over the next 12 months. "5": the security could underperform the local index by more than 15% over the next 12 months.

Disclosure of investment ratings Rating Percentage of total Buy* 70.4% Hold** 21.1% Sell*** 8.5% Source: Daiwa Notes: data is for single-branded Daiwa research in Asia (ex Japan) and correct as of 30 June 2018. * comprised of Daiwa’s Buy and Outperform ratings. ** comprised of Daiwa’s Hold ratings. *** comprised of Daiwa’s Underperform and Sell ratings.

Additional information may be available upon request.

Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Co. Ltd.)

If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items.  In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction.  In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan.  For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements.  There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements.  There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us.  Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.

When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us. Corporate Name: Daiwa Securities Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.108 Memberships: Japan Securities Dealers Association, The Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association