King Digital Is Going To Leave A Lot Of Money On The Table

Mar.14.14 | About: King Digital (KING)

Summary

King Digital Entertainment starts trading on March 26, 2014.

The underwriters have priced it at $21 to $24/share.

My conservative analysis indicates the shares are worth $128 to $142/share.

King Digital's Brilliance

King Digital Entertainment PLC (BATS:KING) acquired Fabrication Games, a small Swedish mobile games developer with just 12 employees for $1 million ($669K net of cash). This key (and its only) acquisition propelled the company's sales from $164.4 million in 2012 to nearly $1.89 billion in 2013 and increased net income by $559.7 million -SWEET.

King has been making casual digital games since its founding in 2003. It focuses on games that are easy to learn and can be played in just a few minutes. CEO Riccardo Zacconi refers to this in the F-1 as "bitesize brilliance." Two of the company's most popular games, Candy Crush Saga and Farm Heroes Saga are puzzle match games, an enduring play style that was invented by Alexey Pajitnov in 1984 with the introduction of Tetris.

Business Model

The company's business model is freemium. Its games are free to download, available for both Android and iOS and seamlessly synchronized between all its users' devices. King promotes the social aspect of its games, encouraging players to reach out to Facebook friends for help. This reduces its CPI, cost per install.

Its revenues come from micro-transactions in which players pay for boosters, more moves to complete a level or more lives to eliminate down times as long as 30 minutes. King has discontinued the sale of "durable" virtual items with lifetimes of 5-8 months and now sells only "consumable" items which are used immediately. Only 1% of 2013 sales came from deferred revenue.

Even though SuperData reported that ads accounted for 20% of sales for social games in 2012, ads were only 10% of King's 2012 sales. The company eliminated all ads in 2013, a move consistent with its emphasis on enhancing user experience. Ads can severely disrupt game play. For example, in competitor Rovio Entertainment's Angry Birds, users can spend as much time staring at ads as playing.

The company's extraordinarily high monthly average spend of $17.32 for Q4 2013 proves its model resonates with users. By comparison, AppLift/Newzoo estimated the 2013 average monthly spend worldwide was just $2.78.

Target Demographics

The company's games are aimed at women 25-55. Its offerings reflect this: casual games based on the number of moves instead of time. Newzoo's 2013 survey results show the company is succeeding with its target users.

Newzoo surveyed players of two of the top grossing games: King's Candy Crush and Supercell's Clash of Clans in Belgium, France, Germany, Poland, Turkey, the Netherlands, the UK and the US. It found:

  • 60% of Candy Crush players are female vs. 23% of Clash of Clans players
  • 42% of Candy Crush players are 21-35 and 40% are older than 35
  • 45% of Candy Crush players identified themselves as "casual" gamers vs. 13% of Clash of Clans players.

Competitive Advantages

1. Its Game Development Process Reduces Chance of Launching Unsuccessful Games

King's social and mobile game development process is not only repeatable, but would be very difficult for competitors to replicate.

  • It has a game format, Saga, which it has already used to develop 3 popular games. Saga is a framework that facilitates developing new games and incorporating popular new features in them.
  • Teams of 3 people create new games in about 20 weeks.
  • The team uploads the new game to royalgames.com for testing. As many as 10 million registered users vet new games in a tournament-style format complete with prizes to encourage participation.

2. Customer Acquisition Costs Are Lower and Its User Revenue Is Higher

While the barriers to entry are low, the bar for success keeps getting higher. Late last year, SuperData estimated that it cost $2.73 in advertising to attract a mobile gamer vs. just $1.96 in average revenue per user. For 99% of game makers, that's a problem. But, not for King. Its average revenue per user is $17.32 and it doesn't rely as much on advertising. Quoted passages are from the F-1.

  • The company's model for getting players is "primarily viral and organic, supplemented by a data-centric, rules-based approach to marketing. The inherently social nature of our games drives virality. This virality is enhanced by our cross-platform synchronization."
  • "We enjoy a virtuous cycle where players that play our games on various platforms and devices share their enjoyment and progress with their friends who in turn then discover our games."
  • "In addition, a large number of players discover our games through organic channels. This results in attracting large numbers of players for whom there is no direct marketing expense."
  • Consequently, King's net margin for 2013 was 30.1% vs. -3.1% for Zynga, Inc. (NASDAQ:ZNGA)

3. King Has a High Percentage of Paying Users

According to Supercell, only 1-5% of a game maker's users are paying users. King is at the high end of that range with about 12 million paying users or 4%.

4. King's Management Is Visionary and Efficient

Management anticipated the importance of mobile gaming and made a key acquisition in 2012 for just $669K net of cash. The results:

  • Mobile revenue increased from 9.9% of sales in 2012 to 70.2% in 2013.
  • Total sales increased 1046% YoY.
  • Net income increased 7035% YoY to $567.6 million in 2013.

King dethroned Zynga by recognizing the shift from social gaming to mobile gaming and emphasizing simpler games better suited to mobile coupled with platform synchronization.

King's processes for developing games and acquiring customers keep costs under control and make use of its dedicated gaming community. King's sales & marketing costs as a % of sales are the lowest and its R&D costs are among the lowest in its peer group as shown in the following table.

Research & Development and Sales & Marketing as a % of Sales

Company

R&D as a % of Sales

S&M as a % of Sales

Activision Blizzard, Inc. ATVI

12.70%

13.20%

Electronic Arts EA

30.70%

19.70%

China Mobile Games & Entert. Group Ltd. CMGE

29.70%

20.10%

Changyou.com Ltd. CYOU

16.30%

17.50%

Take-Two Interactive Software, Inc.* TTWO

5.50%

10.80%

Zynga, Inc.

11.20%

30.40%

King Digital Entertainment PLC

5.90%

5.10%

Click to enlarge

Source: SEC

*Take-Two's R&D costs as a % of sales were averaged over 4 years to get a more realistic picture of its costs since 2013 sales were bolstered by the release of Grand Theft Auto V.

Challenges and Potential Threats

  1. Three games accounted for 94% of 2013 sales, with one, Candy Crush responsible for 78%. The company needs to diversify its revenue base more.
  2. Both its primary and backup servers are in Sweden exposing the company to local outages which could shut down its site.
  3. Growth in markets where the dominant operating systems are other than Android and iOS may be difficult. About half of users' devices in Asia Pacific and the Middle East/Africa don't use Android or iOS.

Market Size, Growth Potential and Opportunities

1. AppLift/Newzoo project mobile gaming will grow at a CAGR of 27.3% through 2016 to $23.9 billion. IDC's estimate is $23 billion by 2017 which results in a CAGR of 17.2% vs. 2013. I believe the higher projection is more likely to be correct because:

  • This market has a history of growing faster than expected. In 2010, Gartner projected sales would grow at a CAGR of 19% from $4.9 billion in 2009 to $11.4 billion in 2014. AppLift/Newzoo's 2013 estimate is $12.2 billion which leads to a CAGR of 25.8% for 2009-2013 - 35.8% higher than Gartner's 2010 estimate.
  • The market grew 34.7% from 2012 to 2013.

2. The Western and Eastern European markets are expected to grow the fastest, at a rate of over 33%.

3. The company is diversifying into Japan and South Korea and it may be able to find a partner in China.

4. The table below shows mobile gamer growth and monetization potential by region on a scale of 1 to 5, with 5 being the highest.

Mobile Gamer Growth & Monetization Potential

North America

Latin America

Western Europe

Eastern Europe (w/ old USSR)

Middle East & Africa

Asia Pacific

User Growth Potential

3

3

4

4

2

3

Monetization Potential

5

3

5

3

2

4

Click to enlarge

Source: AppLift/Newzoo

5. King is well-positioned to profit from this expected growth based on its high market share in Eastern Europe and the greater preferences for the Android and iOS operating systems in North America, Latin America and Europe as shown in the following 2 tables. Its Candy Crush is the top grossing game on Android in Argentina, Brazil and Mexico and number one on the iPhone in Brazil and Mexico and on the iPad in Argentina and Mexico.

Regional Breakdown of Mobile Payers and King's Share

North America

Western Europe

Other Europe (w/ old USSR)

Rest of World

Total

Total Payers

65 million

43 million

27 million

233 million

368 million

Avg. Monthly Spend

$3.87

$4.40

$1.27

$2.35

$2.78

Total 2013 Global Revenue

$3 billion

$2.3 billion

$420 million

$6.56

$12.28 billion

King 2013 Revenue

$1.07 billion

$334 million

$150 million

$330 million

$1.884 billion

King Share

35.70%

14.50%

35.70%

5.00%

15.30%

Click to enlarge

Sources: AppLift/Newzoo, SEC (F-1)

(It should be noted that given $12.28 billion for global 2013 sales and assuming a CAGR of 27.3%, projected global sales in 2016 are $25.3 billion.)

Global Operating System Penetration

Operating System

North America

Latin America

Western Europe

Eastern Europe (w/ old USSR)

Middle East & Africa

Asia Pacific

Android

37%

46%

49%

50%

38%

46%

iOS

54%

25%

41%

21%

12%

7%

Other

9%

29%

10%

29%

50%

47%

Click to enlarge

Source: AppLift/Newzoo

6. If King just maintains its market share of 15.3%, its sales could more than double by 2016.

VALUATIONS

Intrinsic Valuation Assumptions

Based on King's geographical sales breakdown as provided in the F-1, capitalizing its operating leases, using 4.20% as its pre-tax cost of debt and 2.70% as the risk-free rate, the initial cost of capital (COC) is 10.02%. After ten years, there are no excess earnings and the firm earns its COC, which is 7.20% after 2023.

The tax rate for the first 5 years was 20.54%, the same as the company's 2013 effective tax rate. The tax rate was gradually increased to the Maltese marginal tax rate of 35% over the next 5 years and in perpetuity.

The company's sales grew at a CAGR of 27.3% through 2016 and then gradually slowed to the growth rate of the US economy of 2.7% (same as the risk-free rate) in 2023 and beyond, maintaining its market share at 15.3%.

R&D expenses were capitalized over an 18 month period based on the company's statement that this is the amortization period it uses. After capitalizing both R&D and operating leases, the company's initial pre-tax operating margin was 42.15%. To be conservative, the target pre-tax operating margin in 2023 was 33.8%, the same as Activision Blizzard's adjusted trailing 12 month [TTM] pre-tax operating margin.

I estimated the sales-to-capital ratio for King based on the average actual ratios for Activision Blizzard and Electronic Arts. Activision's 9-year average sales-to-capital ratio was 8.9. Electronic Arts' was much lower at 1.3 due to its many acquisitions. Again, to be conservative, I used the average of 5.1 for King.

Intrinsic Valuation Results

Based on these assumptions, the company's projected sales in 2016 are $3.89 billion and $7.35 billion in 2023. Sales in the terminal year are $7.55 billion. The DCF results are tabulated below. All amounts are in millions of USD.

Intrinsic Valuation Results

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

Sales

$2,399

$3,054

$3,887

$4,812

$5,666

$6,307

$6,710

$6,962

$7,160

$7,354

Operating Income

$991

$1,236

$1,541

$1,867

$2,152

$2,342

$2,436

$2,469

$2,480

$2,486

Net Operating Income

$797

$982

$1,225

$1,484

$1,710

$1,794

$1,795

$1,748

$1,684

$1,616

Reinvestment

$101

$128

$164

$181

$168

$126

$79

$49

$39

$38

FCFF

$696

$854

$1,061

$1,303

$1,542

$1,668

$1,716

$1,699

$1,645

$1,578

Click to enlarge

The company's estimated value is $18.05 billion, which includes $349.5 million in IPO proceeds to the company from its issuance of 15,533,334 shares sold at $22.50, the midpoint of the price range. Assuming 126.8 million shares outstanding after the IPO, the share value is $142.33.

Relative Valuation

The company's peer group consisted of five of the companies previously mentioned: Activision Blizzard, Electronic Arts, China Mobile Game and Entertainment, Changyou.com and Take-Two Interactive. All data are as of Noon on February 28, 2014.

1. Price/Sales Regression

For the Price/Sales (P/S) regression, the regression variables chosen to represent growth, profitability and risk were: Expected YoY EPS Growth, Net Margin and Total Debt to Equity, respectively. Zynga dropped out of the comparable firms because it posted a loss for 2013, so its EPS growth could not be calculated.

The constant was not significant. EPS growth and net margin were significant with t-statistics greater than 2.

The R-Squared was 0.998, meaning 99.8% of the variation in the P/S ratios of these 5 comparable firms was explained by the chosen variables. The signs of the coefficients were as expected, positive for EPS growth and net margin and negative for total debt to equity. The model is:

Price/Sales = 7.58 x Expected EPS Growth + 20.95 x Net Margin.

Assuming King's sales grow 27.3% in 2014 and its operating expenses as a percentage of sales are the same as they were in 2013, its earnings growth would be 30.4%. Plugging in 30.4% for EPS growth and 30.1% for its net margin (same as in 2013), the predicted P/S is 8.62:

Predicted Price/Sales = 7.58 x 0.304 + 20.95 x 0.301 = 8.62.

King's value based on its 2013 sales of $1.8843 billion is: $16.2 billion or $128.05/share.

2. Price/Book Value of Equity Regression

For the Price/Book Value of Equity (P/BVE) regression, the regression variables chosen to represent growth, profitability and risk were: Expected YoY EPS Growth, ROE and Total Debt to Equity, respectively.

Setting the constant to zero, resulted in an R-Squared of 0.885. The only significant variable was expected earnings growth. But the sign for the total debt to equity coefficient was positive instead of being negative and two of the predicted P/BVEs for the 5 comparable firms were negative, so this model was rejected.

3. Price/Book Value of Assets Regression

For the Price/Book Value of Assets (P/BVA) regression, the regression variables chosen to represent growth, profitability and risk were: Expected YoY EPS Growth, ROA and Total Debt to Equity, respectively.

The constant was not significant. The R-Squared was 0.983. All the signs for the coefficients were as expected: positive for earnings growth and ROA and negative for total debt to equity. The only significant variable was expected earnings growth. But, like the P/BVE regression, the model predicted negative P/BVAs for two of the 5 firms. Therefore, this model was also rejected.

Conclusions

  1. Based on DCF and relative valuations, the estimate for King's value ranges from approximately $128 to $142/share.
  2. I think this valuation is conservative and that the price range set by the underwriters greatly undervalues the company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.