Edited by Vani Rao
Shares of King Digital Entertainment fell 15.56% since its maiden market debut
Warning flags are starting to go up on Wall Street. After wrapping up one of its best years in recent history, the “froth fizzled out” of the stock market. Many “hot momentum stocks” — including investor favorites like Facebook (NASDAQ:FB) and Tesla Motors Inc. (NASDAQ:TSLA) “are getting slammed.” Even mutual fund investors are nervous, having taken $4 billion out of US stock funds last week alone. It is not clear yet whether the selling spree will get worse, and investors may be preparing to “buy the dip.” But for now, it is clear that “skittishness is making a comeback.”
These days, it seems like every hot start-up IPO is commanding prices that some strategists say will turn out to be unsupportable. Take, for example, King Digital Entertainment’s recent IPO. At the end of March, King Digital Entertainment (NYSE:KING) made its official debut on the New York Stock Exchange. King Digital is the developer of the classic game Candy Crush. After opening at $20.50 a share, King Digital Entertainment fell 15.56% in its debut to close at $19.00.
While King Digital offers other mobile games such as Pet Rescue Saga, Farm Heroes Saga, and Bubble Witch Saga, the firm’s success is heavily reliant on the success of Candy Crush. The game has become so synonymous with King Digital Entertainment that its recent IPO has been referred to as The Candy Crush IPO.
Investors, it seems, aren’t willing to bet on a company whose revenue is so heavily concentrated in one basket, albeit a wildly popular one. While the company has an intellectual property portfolio of 180 games and counting, Candy Crush Saga generated a whopping 78% of King’s bookings in the fourth quarter of 2013.
What happens, then, when Candy Crush mania begins to fade? One only has to look as far as Zynga Inc. (NASDAQ:ZNGA), maker of the once ubiquitous FarmVille, for a possible trajectory. Its stock price is half of what it was when it went public in 2011, and its revenues have suffered as the company has failed to produce another hit game.
Dismal predictions aside, King Digital is currently a profitable company. Unlike recent IPO superstars like Twitter Inc. (NYSE:TWTR) and Zulily Inc. (NASDAQ:ZU), the company was profitable before it went public, generating $568 million in net income in 2013 on revenues of $1.9 billion.
The market is viewing King Digital as a company whose profits are temporarily high from a successful game. The business is similar to producing movies; a blockbuster will temporarily lift profits, but to maintain profits, the company must continue to produce blockbusters, which is hard to do so. In other words, despite its profitability, King Digital failed to convince investors that it can create a string of hits.
King has two options. The first is to release a game that matches Candy Crush’s popularity, a feat easier said than done, given the intense competition in the free-to-play games market. The second option is to make acquisitions, but this can be a dangerous path to follow. Zynga has spent quite a bit of money on acquisitions in the past, and the results have not been great. The company spent nearly $200 million on OMGPOP, the developer of Draw Something, at about the same time the game peaked.
Earlier this year, Zynga spent $527 million on another acquisition, Natural Motion, and the results are expected to be similar to the OMGPOP debacle. King Digital needs to avoid the trap that Zynga fell into, that of overpaying in an act of desperation. The fact that King Digital could be valued in the same ballpark as popular game makers Hasbro Inc. (NASDAQ:HAS) at $7.23 billion and Electronic Arts (NASDAQ:EA) at $8.83 billion, while having the majority of its business from one revenue stream is outlandish. Even with a relatively low P/E ratio, it seems that King Digital is nothing but a value trap. The mobile entertainment industry has extremely low barriers to entry and any change in player sentiment will prove catastrophic.
With 93 million average daily active users (DAUs), Candy Crush accounts for nearly 73% of King Digital’s overall DAUs. The game accounts for nearly 80% of King’s revenue, propelling the company’s mobile revenue from $16 million to $460 million in the last four operating quarters. At the same time, Candy Crush has enabled King’s mobile gross bookings as a percentage of total gross bookings to increase from 23% to 73%.
Yet, there seems to be some evidence that revenue from Candy Crush has slightly declined. According to King’s IPO, total revenue declined from $621 million to $602 million in the quarter ended December 31, 2013. During the same quarter, its gross bookings declined from $648 million to $632 million. However, the disturbing aspect of the gross bookings decline was that it was driven by a fall in Candy Crush gross bookings. This may be a sign that interest in Candy Crush may have already have reached its peak and is set to witness a decline in future months.
Zynga has never been able to come up with a stalwart that has been as successful as Farmville. Rovio has failed to develop a second strong mobile game besides the iconic Angry Birds. Similar to other iconic games, social media sites and societal trends, an individual will eventually lose interest and pursue the next big thing.
Thus, King Digital is in a hurry to create a second game that will rival or surpass the popularity of Candy Crush. As a result, the company has posted 165 job openings in order to ramp up its overall expertise. Nearly 47% of job openings are in the areas of development, engineering, and design.
History is not on the side of King Digital when it comes to a gaming firm following up on its initial breakout hit. The bar has been raised; a single cash cow, no matter how lucrative, is not enough. Instead, mobile gaming companies now have to prove they have a host of juicy calves waiting to be brought to pasture. And that’s hard to do.