Korea Information Technology 11 July 2018 Pan-Asia Internet and Online Games 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? 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] 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 2 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 3 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 4 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).