Want to buy some Mu?

International investors can buy exposure to Asia''s thriving online gaming world through the ADR of Webzen.

If you are over 30 years old, the probability is you have never played an online videogame and the phenomenon may have passed you by. Fund managers, however, no longer have the luxury of ignoring this high growth sector and thanks to the forthcoming ADR of Korea's Webzen, many are busily trying to understand the business model.

Webzen plans to launch a $100 million ADR via JPMorgan in early December and as such will be the first online gaming company to issue an ADR and thus target international investors.

It is, of course, a very young company and is the hottest in the sector. It was listed on Kosdaq in May at an issue price of W32,000 and has since seen its stock skyrocket to a high of W160,300. However, this is no simple dotcom story. What is phenomenal about these online gaming companies is they are actually profitable and getting more so at a rate of growth which is hard to match in any other industry.

Webzen's 2001 revenues, for example, were W2.3 billion, versus a UBS estimate of W56 billion for this year and an estimate of W98 billion by 2005. Based on these numbers profit has risen from W871 million in 2001 to (UBS estimates) W30.1 billion this year and W56 billion in 2005. The actual profit for the first six months was W16.5 billion ($13.8 million).

The business model is based on subscription, and in this respect it might seem similar to a media stock such as Astro or BskyB. However, it is subtly different. Webzen earns its money from a single, and highly popular game called Mu. This is a three-dimensional roleplaying game where players spend hours as a character in an interactive world playing against other humans. The game is violent and 90% of the users are males between 15-25 years old.

The online game world has benefited massively from the growth of broadband, which allows people to play the games fast and efficiently from their homes. The key metric used to analyse the success of an online game is the number of concurrent users, ie how many people are playing the game at the same time. Mu was launched last year and has been a staggering success thanks to it pioneering use of a 3-D game world. It has seen its concurrent users rise to 67,000 in Korea in just a year.

Even more impressive, it signed a licensing agreement with the9.com in China to launch Mu on the mainland and it has gained 300,000 concurrent users in an even shorter timeframe.

The game itself is highly addictive, and rewards those players who play for the longest time, which is a fairly savvy approach from a business perspective. That's because the longer a user plays the more 'powers' or 'attributes' their character develops, which in a fight with another user means the player who has played the game longest has a better chance of winning.

Mu is one of several popular online games in Korea, with NCSoft's Lineage being the first. Five years after launch, Lineage remains very popular and retains market leadership with 120,000 concurrent users in Korea. Indeed, NCSoft is the market leader in the online gaming sector in Korea with a 34% market share in 2002. NCSoft has also launched Lineage 2, which is also 3-D, in large part to compete with Webzen's Mu.

Notably, the online gaming industry is growing faster than any other part of the games world. It has gone from being 7% of the global video games market in 2001 to 12% this year and has taken share from public video arcades, consoles and non-online PC games. In the US the biggest player is Sony's Everquest which has 430,000 subscribers.

The three core markets are Korea, the US and China. The total subscription revenues of the Korean online game market in 2002 were $289.5 million, as compared to $162.7 million in 2001. According to IDC's April 2003 report, China's online game market recorded aggregate subscription revenues totaling approximately $96.5 million in 2002, as compared to approximately $45.7 million in 2001. By comparison, according to IDC's July 2003 report, overall United States subscription and related revenues from online games were estimated to be approximately $208.2 million in 2002 and $202.5 million in 2001.

China is where the most growth is expected. In October Webzen's China royalty revenue hit a new monthly high of $0.64 million, which was month-on-month increase of 40%.

Billing can be done by the minute or on a monthly basis. In the case of Mu, 92% of its online PC subscriber base chooses to be billed for flat rate periods of 30 or 90 days versus being billed by the hour. In Korea, the flat rate fee for 30 days is W27,500.

As Lineage has proven, once you build a very good game the lifecycle of the product is over five years. Indeed, because the developers keep releasing new 'episodes' to keep users hooked, the best analogy for these games is with a soap opera, ie the life cycle can go on and on and on (as for example, Coronation Street in the UK continues to do). This means that once development costs are covered, almost ever dollar falls to the bottom line. The operational costs are low and mostly revolve around running the servers and developing either new games or new 'episodes' for existing games (Webzen has about 180 staff).

Webzen's main competitor is obviously NCSoft, which has also talked of doing an ADR but will lose the mantle of being first to its smaller, but faster growing rival. Where Webzen has stolen a march on NCSoft is in accumulating more users in China, which from an investor's point of view is where the growth is mainly going to come from - since Korea's online gaming market is viewed as being mature. There are 12 million online game users in Korea already.

Webzen is a lot younger than NCSoft and this is reflected in the management team. Its CEO, Nam-ju Kim is only 31 years old. The four original company founders still control 27% of the stock.

The company is currently sitting on about $20 million of cash, so why does it need to raise $100 million in an ADR? In its use of proceeds statement, the company hints at expansion in the US (through possible acquisition) and the use of cash to develop new games. Clearly, it is a fast moving industry and there will be an advantage to sitting on a lot of cash so as to buy younger companies that generate great new games. Cash-wise the two dominant players in Korea will thus be Webzen and NCSoft.

The industry's growth projectile is hard to dispute, but what could go wrong? From an investor's perspective probably the greatest risk is of the operational variety. As Webzen states in its prospectus: "Any failure to maintain the satisfactory performance, reliability, security and availability of our network infrastructure may cause significant harm to our reputation and our ability to attract and maintain subscribers. The principal system hardware for our Korean operations is located in a single location in Seoul and our principal system hardware for our China operations is located in a single location in Shanghai. We do not maintain full backup system hardware in either location.

"Accordingly, any server interruptions, break-downs or system failures, including failures which may be attributable to sustained power shutdowns or efforts to gain unauthorized access to our systems causing loss or corruption of data or malfunctions of software or hardware equipment, or other events outside our control that could result in a sustained shutdown of all or a material portion of our services, could adversely impact our ability to service our subscribers."

This is not a far-fetched risk. Webzen's network went down for three hours in May due to a computer virus attack.

And as Philip Kim, who runs Korea for tech boutique IRG says: "This ADR will build a growing awareness of this unique and powerful business model. However, the challenge will be for this young management team to meet the expectations of the most sophisticated investors."

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