KOREA - EQUITY RESEARCH Internet 13 October 2006 NCSOFT (036570) Upgrade to Overweight Share price fell sharply due to lower 2006F earnings guidance. However, 3Q06F earnings Until th Overweight will likely exceed our expectations by a notable margin. NCsoft plans to unveil Aion, its new MMORPG (Massively Multiplayer Online Role-Playing Chang Kwean Kim Game), at the game expo called G-Star (Game Show and Trade All Round) during +822-768-4321 ESEARCH November 9~12 in Korea. This will be a key opportunity for an early review of the new [email protected] R game, which is expected to have a critical affect on the company's share price. We revise up NCsoft from Trading Buy to Overweight based on the following. First, we Bloomberg: 036570 KS QUITY adjust up our earnings forecast for the second half. Second, a detailed schedule for new Reuters: 036570.KS E game introductions will be announced. Third, management is taking concrete steps to Target price (6M): W65,000 control costs. We also upgrade our six-month target price from W60,000 to W65,000. Share Price (12/10/06): W52,100 NCsoft became a forerunner in MMORPG (Massively Multiplayer Online Role-Playing Game) with Par Value: W500 the commercialization of Lineage in September 1998, The game served as NCsoft’s single 52-W Lo/Hi: W41,100/98,400 revenue source until the company commercialized Lineage 2 in October 2003. KOSPI: 1,331.8p Since the launch of Lineage 2, the domestic market has contributed little to the top line growth Mkt Cap: US$1.1bn/W1,062.2bn of NCsoft until 2005, which was primarily driven by overseas sales. However, their new games Shares Issued: 20.4 mn shr faltered in the overseas markets in 2006, and their new casual games were not a commercial success in the domestic market. This along with the weight of increased new game Avg Volume (60D): 188,758 shr development costs, lead to the stumbling of the company’s top line and deterioration of profit. Avg Value (60D): US$9.0mn/W8.7bn Still, even in this negative operating environment, NCsoft remains the leading global MMORPG Foreign Ownership: 42.1% developer and publisher. Dividend Yield (2005): 0.0% Quarterly earnings are gradually improving with 2Q06 as bottom. We expect to see an increase Major Shareholder(s): in recurring profit in 3Q06F on cost savings and improved earnings from its overseas T. J. Kim (27.44%) subsidiaries. In 4Q06, profitability should rise further, as NCsoft will unveil Guild Wars Robert K. Garriott (2.38%) Nightfall, the third version of Guild Wars, a CORPG (Competitive Online Role Playing Game) that Price Performance became a big hit in the US and Europe. (%) 1M 6M 12M In 2007, commercialization is scheduled for two MMORPGs - Aion currently under development Absolute 5.4 -27.2 -43.1 in Korea and Tabula Rasa being developed in its studio in the US. We expect positive Relative 5.1 -23.5 -52.5 momentum for the shares, as 3Q06 results will likely exceed expectations and its new game Aion will be displayed at Korea’s game expo G-Star. EPORT R Forecasts/Valuations KOSPI Relative performance Chart FY Sales OP NP EPS yoy FCF ROE P/E P/B EV/EBITDA Share price 140 KOSPI (Wbn) (Wbn) (Wbn) (W) (%) (Wbn) (%) (x) (x) (x) OMPANY 120 C 12/04 246.9 109.0 74.1 3,855 30.4 108.9 27.6 21.7 5.3 11.9 100 80 12/05 232.8 72.0 66.7 3,305 -14.3 -21.6 18.7 23.2 4.0 15.8 60 12/06F 226.6 53.1 33.6 1,649 -50.1 4.8 8.3 31.6 2.6 12.1 40 DWS DWS 20 12/07F 277.4 77.4 68.7 3,373 104.6 29.0 15.3 15.4 2.2 7.6 0 10/05 2/06 6/06 10/06 12/08F 299.1 85.9 85.9 4,213 24.9 46.3 16.3 12.4 1.9 6.4 Source: Company data, Daewoo Securities Please carefully read important notices in the last pages of this report. 13 October 2006 NCsoft SOLID EARNINGS EXPECTED IN 2H06 NCsoft made a drastic downward adjustment in its 2006F earnings guidance to reflect the potential cost increase of new game development. However, its earnings are expected to turn out solid in the second half, as personnel cost increase is forecast to be marginal in 2006 compared to 2005. NCsoft has already written-off the one-off development cost related to the game Auto Assault in 2Q06, which will add to its profitability in the second half. A slight increase in Lineage 1 and 2’s market share at PC rooms during the summer silenced concerns of potential revenue reduction from intensifying competition. 3Q06F sales and operating profit should increase 1.0% qoq to W56.1bn and 6.7% qoq to W13.3bn, respectively. Net losses should turn into a net profit of W1.31bn. Table 1. Quarterly earnings forecasts (Wbn) 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06F 4Q06F Sales 60.4 57.2 57.2 58.0 57.4 55.5 56.1 57.7 Lineage I 26.3 26.1 26.2 27.7 28.3 26.8 25.6 26.4 Lineage II 22.5 20.4 21.2 20.8 20.7 20.2 21.5 21.6 New games 0 0.6 0.8 0.1 1.2 0.2 0.2 0.3 Overseas 11.6 10.1 9.0 9.3 8.1 8.3 8.7 9.4 Sales breakdown (%) Lineage I 43.5 45.6 45.7 47.8 49.3 48.3 45.8 45.7 Lineage II 37.3 35.7 37.0 35.9 36.1 36.3 38.3 37.4 New games - 1.1 1.5 0.3 2.2 0.4 0.4 0.6 Overseas 19.2 17.6 15.8 16.0 14.2 15.0 15.5 16.2 Growth (% qoq) Sales -3.5 -5.2 0.1 1.3 -1.0 -3.3 1.02.9 Lineage I 1.3 -0.7 0.3 6.0 2.0 -5.2 -4.3 2.8 Lineage II -14.6 -9.4 3.8 -1.8 -0.5 -2.7 6.6 0.4 New games 0.0 0.0 33.2 -82.1 730.2 -83.6 18.2 41.7 Overseas 13.1 -13.0 -10.1 2.6 -12.3 2.4 4.2 7.9 Operating profit 213 188 181 138 136 125 133 137 Operating margin (%) 35.3 32.8 31.6 23.9 23.6 22.5 23.7 23.8 % qoq -1.0 -11.9 -3.6 -23.6 -2.0 -8.1 6.7 3.1 Recurring profit 173 177 238 227 89 30 173 184 Recurring margin (%) 28.7 30.8 41.7 39.2 15.5 5.4 30.9 32.0 % qoq 11.8 1.8 35.1 -4.7 -60.9 -66.3 478.0 6.5 Net profit 126 129 204 207 68 -2 131 139 Net margin (%) 20.9 22.6 35.6 35.7 11.9 -0.4 23.3 24.1 % qoq -8.4 2.4 57.6 1.5 -67.0 TR TB 6.5 Source: Company Data, Daewoo Securities 2 13 October 2006 NCsoft Chart 1. Lineage I and II game market shares at PC rooms (%) Lineage 18 Lineage II 16 14 12 10 8 6 4 2 0 1/04 3/04 5/04 7/04 9/04 11/04 1/05 3/05 5/05 7/05 9/05 11/05 1/06 3/06 5/06 7/06 9/06 Source: Gametrics AION TO GO ON DISPLAY IN NOVEMBER AT GAME EXPO AION will be the first MMORPG to be developed by the proprietary R&D capacity of NCsoft since Lineage 2. AION will hold the key to 2007F earnings and share performance. The game is expected to have the high graphic quality of Linage 2, and highly engaging storylines like WOW (World of Warcraft by Blizzard). AION will introduce a new game-playing scheme of PvPvE (Player vs Payer vs Environment). This is a hybrid of PVP (Player vs Player, users against other users) and PvE (Player vs Environment, users against non-players such as monsters). NCsoft will partially showcase the beta-version of AION with some added game items at the G-Star game expo in November to take place in Korea. The launch schedule of other new games should become clearer in 4Q06. Guild Wars Nightfall, the third version of Guild Wars will go on sale in the US, Korea and other Asian nations at the same time in 4Q06. NCsoft also plans to offer a beta service of MMORPG Tabula Rasa, which is currently being developed in its US studio in 4Q06. Table 2. Game product lineup of NCsoft 1Q06 2Q06 3Q06 4Q06 City of Heroes Guild Wars Nightfall Korea Guild Wars Factions Exteel Aion (Beta test) Guild Wars Nightfall North America/ Guild Wars Factions Tabula Rasa (Beta test) Europe Auto Assault Exteel Dungeon Runners Asia Guild Wars (Japan, Taiwan) Guild Wars Factions Guild Wars Nightfall Source: Company Data 3 13 October 2006 NCsoft NCsoft (036570) - Financial Statement Balance Sheet (Summarized) Income Statement (Summarized) (Wbn) 12/05 12/06F 12/07F 12/08F (Wbn) 12/05 12/06F 12/07F 12/08F Current assets 270.0 294.8 352.4 379.9 Sales 232.8 226.6 277.4 299.1 Cash and cash equivalents 10.4 18.1 21.5 23.2 Cost of goods sold 38.3 38.0 46.9 49.9 Short-term financial goods 230.0 240.3 286.3 308.7 Gross profit 194.5 188.7 230.5 249.1 Accounts receivable 20.1 22.3 27.3 29.4 SG&A expenses 122.5 135.6 153.1 163.3 Inventories 0.0 0.0 0.00.0 Operating profit 72.0 53.1 77.4 85.9 Other current assets 9.5 14.1 17.2 18.6 Non-operating profit 9.5 -5.4 13.6 27.9 Non-current assets 151.5 168.6 195.9 213.0 Interest income/expenses 8.3 10.8 12.2 13.8 Investment assets 76.7 64.2 70.0 72.4 FX-related gains/losses -0.9 -0.5 0.0 0.0 Tangible assets 72.1 102.2 124.0 139.0 Equity method gains/losses 1.2 -16.5 0.5 13.2 Intangible assets 2.7 2.3 1.9 1.6 Asset disposal gains/losses -0.2 -0.1 0.0 0.0 Total assets 421.6 463.4 548.3 593.0 Other non-operating profit/losses 1.1 0.9 0.9 0.9 Current liabilities 22.5 27.8 34.1 36.7 Recurring profit 81.6 47.6 91.0 113.7 Accounts payable 0.0 0.0 0.0 0.0 Extraordinary gains/losses 0.0 0.0 0.0 0.0 Short-term borrowings 0.0 0.0 0.0 0.0 Pretax profit 81.6 47.6 91.0 113.7 Current portion of long-term debt 0.0 0.0 0.0 0.0 Tax 14.9 14.0 22.3 27.9 Other current liabilities 22.5 27.8 34.1 36.7 Net profit 66.7 33.6 68.7 85.9 Non-current liabilities 5.7 7.3 6.9 6.4 Free cash flow -21.6 4.8 29.0 46.3 Bonds 0.0 0.0 0.00.0 Residual income 66.7 33.6 68.785.9 Long-term debt 0.0 0.0 0.0 0.0 EBITDA 83.8 66.3 98.9 114.1 Other non-current liabilities 5.7 7.3 6.9 6.4 Depreciation of tangible/intangible assets 11.8 13.3 21.5 28.2 Total liabilities 28.2 35.1 41.0 43.2 Gross margin (%) 83.6 83.3 83.1 83.3 Capital stock 10.2 10.2 10.2 10.2 EBITDA margin (%) 36.0 29.3 35.7 38.2 Capital surplus 396.4 431.3 500.0 585.9 Operating maring (%) 30.9 23.4 27.9 28.7 Capital adjustments -13.2 -25.2 -25.2 -25.2 Recurring margin (%) 35.0 21.0 32.8 38.0 Total stockholders' equity 393.4 416.3 485.0 570.9 Net margin (%) 28.6 14.8 24.8 28.7 Cash Flow (Summarized) Forecasts/Valuations (Summarized) (Wbn) 12/05 12/06F 12/07F 12/08F 12/05 12/06F 12/07F 12/08F Cash flow from operating activities 67.2 64.0 87.8 100.1 P/E (x) 23.2 31.6 15.4 12.4 Net profit 66.7 33.6 68.7 85.9 P/CF (x) 19.9 23.0 11.8 9.3 Non-cash income and expense 16.8 33.1 22.7 16.9 P/S (x) 6.7 4.7 3.8 3.6 Tangible assets depreciation 11.2 12.5 20.9 27.7 P/BV (x) 4.0 2.6 2.2 1.9 Intangible assets depreciation 0.5 0.7 0.6 0.5 P/EBITDAPS (x) 18.5 16.0 10.7 9.3 Others 5.0 19.9 1.2-11.3 EV/EBITDA (x) 15.8 12.1 7.6 6.4 Chg in assets & liabilities from oper.