The Crush with Candy

Edited by Vani Rao

King Digital looking to mop up $7.6 billion in its IPO on its game popularity logo

Dublin-based King Digital Entertainment, best known for the hit mobile phone game “Candy Crush Saga”, said it expects to price its initial public offering (IPO) at between $21 and $24 per share, valuing the company at about $7.56 billion (€5.45 billion). King, whose owners include Apax Partners and venture capital firm Index Ventures, intends to raise about $533 million by listing on the New York Stock Exchange (NYSE) under the symbol “KING”.

Candy Crush Saga was the most downloaded free app of 2013 and the year’s top revenue-grossing app. It has been downloaded more than 500 million times since its launch in 2012. The basic game is free, but players must pay for add-ons or extra lives. King offers 180 games in 14 languages through mobile phones, Facebook Inc. (NASDAQ:FB) and its own website. The company says that its games are played more than one billion times a day, but is heavily reliant on Candy Crush, which brings in about 75% of its revenues. The demand for the puzzle game, which features different coloured candies, drove an 11-fold surge in revenue in 2013 to $1.9 billion.

King reported revenue of $60 million in 2009, $58 million in 2010, and $64 million in 2011. However, it wasn’t until Candy Crush emerged in 2012 that revenue shot up to $164 million in 2012 and $1.9 billion last year.

Fourth-quarter revenue of $602 million was down 3% from the third quarter, the first time that King disclosed that revenue declined on a quarterly basis. And while the total number of users continued its heady rise, the average number of paying users also declined in the fourth quarter as compared to the third.

One-hit Wonder

Research shows that creating hits in digital storefronts like Apple’s iTunes is a near random process, almost unpredictable and with only a loose connection to the quality of the offerings. In one experiment, Princeton Professor Matt Salganik found that letting people see how many times a song had been downloaded was an overwhelming influence over future popularity. As social rankings were made more and more obvious, the emerging hits got bigger and more unpredictable.

To be sure, Candy Crush was developed with attention to the same kinds of psychological factors that casinos use to attract slot machine players. The question for investors, of course, is whether King owns a one-hit wonder or a more dependable hit factory.

Many see King as the next Zynga Inc. (NASDAQ:ZNGA) or Groupon Inc. (NASDAQ:GRPN) companies that drove on a fad and went public at the height of their popularity only to burn investors when the inevitable fade arrived. King is hoping to convince investors that it will be able to replace the outmoded addiction with something new. So far, the evidence is missing.

Make Hay While the Sun Shines

The successful IPO of Twitter Inc. (NYSE:TWTR) in November and a surge in Facebook Inc.’s share price have fuelled speculation about the market entry of many technology firms such as music-sharing service Spotify, lodging service AirBnB, and payments company Square. King should also get a boost in its US IPO following a surge in shares of digital coupon company Inc. (NYSE:COUP) after it went public on Friday. Shares of doubled after being priced above the company’s planned IPO range.

The Numbers Game

King will sell 15.5 million shares in the IPO, while stockholders, including Apax Ventures, will sell 6.7 million shares. The King IPO will raise as much as $532.8 million at the top-end of the price range. King filed for a $500-million placeholder in February this year.

Melvyn Morris chairman of King owns 11.3% stake or 35.6 million shares, that would be worth more than $854 million at the high end of the IPO price range, while chief executive Riccardo Zacconi’s 9.6% stake, or 30 million shares, would be worth a little over $728 million. King’s single largest shareholder, private equity firm Apax Ventures, will own a stake worth $3.83 billion if outstanding shares go for $24 a pop. The firm currently owns a 48% stake in the company but is accounting for 6.6 million of the 22.2 million shares up for grabs in the IPO. Even after the 6.6 million shares are sold, Apax will remain King’s largest shareholder with a stake worth 44.8%.

Risks Galore

King Digital Entertainment enjoyed massive and rapid growth thanks to its highly addictive digital offspring. In February alone, Candy Crush garnered 97 million daily active users and over one billion daily game-plays. However, with a litter of once-hot apps in its wake such as Farmville, Fruit Ninja, and Angry Birds, the question is not if King Digital can reach its $7.6 billion target, but whether it can avoid the fate of Zynga, the company behind the once-viral Farmville, which has now faded from public memory.

Source: Bloomberg
Source: Bloomberg

Zynga was listed in 2011 with a $7-billion valuation, or $10 per share. The stock hit its peak level of $14.69 per share in February 2012, but has remained on a downward path ever since. Zynga currently trades around $5.80 a share, a more than 40% decline from its stock market debut. Ironically, it was King’s Candy Crush that ousted Farmville as the most-played app on Facebook.

King acknowledged the risks, noting that while it witnessed a significant growth in operations, only a small number of games currently generate a substantial majority of its revenue. Moreover, King faces significant competition; if players do not find its casual game formats compelling and engaging, it could lose players and revenue could decline. It may also experience fluctuations in our quarterly operating results due to a number of factors, which makes the future results difficult to predict.

The Mobile World

Candy pic 3

Mobile games are a strangely perplexing market. Candy Crush is not particularly innovative, or even new. In fact, it can be called as an evolved clone of Bejeweled, a game launched in 2001.

Mobile games, like internet videos can go viral. Take, for instance, the phenomenon of Flappy Bird, which stormed onto the scene earlier this year and topped Apple Inc.’s (NASDAQ:AAPL) and Google Play game charts, until its creator couldn’t take the pressure and pulled it off the market. Flappy Bird is no longer available, but 4 of the top 30 trending free games in the Google Play store are Flappy Bird knock-offs, meaning that the mobile game market has very low entry barriers.

Comparing King with EA (NASDAQ:EA) which has a market cap of $9.2 billion is one of the biggest player in the gaming industry, creates money-making games like Madden, FIFA, Need for Speed, Mass Effect, which contain vibrant environments, lifelike characters, and deep storylines. EA makes its own mobile games alongside the huge productions that can only be played on consoles and PCs. “Plants vs. Zombies,” an EA production currently ranks third among the top paid games on the Google Play store.

Given this scenario, something smells wrong with King’s $7-billion valuation, which gets relatively close to EA’s value; especially when we consider King’s 4Q decline in revenue. King does make a valiant argument, with its 2013 revenue of $1.9 billion reaching just under half that of EA’s FY2013 revenue, while EA does struggle with profit margins given its high game development budgets. Hence, one must take into consideration the unpredictability of the mobile games market as a whole. It’s also a far more accessible place for competitors, where the likes of Dong Nguyen and his Flappy Bird found a way to challenge King for the top spot.

The Free gaming Model

King’s startling growth in recent years is further proof of how the so-called freemium games have upended the conventional business model of the mobile games industry. In this approach, games are free for anyone to play, but players may buy virtual items such as a costume to decorate a character or opportunities to accelerate their progress in these games. The vast majority of players in most of these free games never buy anything. The small percentage who do, though, often spend with abandon.

The freemium approach to games first took off in Asia more than a decade ago, where high rates of software piracy forced game publishers, like Nexon, to come up with innovative ways to profit from their creations. Zynga was among the first wave of US companies to successfully import the business model with Facebook games like FarmVille.

Should King persuade investors to pay at the top end of the range, its stock would be valued 54% higher than that of Zynga, the publisher of FarmVille and Words With Friends. It certainly brings up the question as to whether King deserves such high valuations even though it is debt-free. History suggests that one-hit wonders are not able move beyond their genius; for instance, Zynga has never been able to replicate the success that it enjoyed with FarmVille. Angry Birds is still by far Rovio’s most successful product. King itself has released a couple of successors to Candy Crush, but neither is a breakthrough. We hope that history does not repeat itself.

If King stayed private, it could milk its cash cow and build games without having to worry about hatching a new cultural juggernaut. We expect companies to constantly be in search of the next big thing. But for one-hit wonders, the smartest strategy might be to just enjoy while it lasts.

The market is indeed unforgiving…

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