- King Digital appears to be a dangerous investment due to the risk of its games being a short-term fad.
- There is little barrier to entry in the mobile game business and King's revenue stream is concentrated in very few games.
- King's revenue is made through in-app purchases and it is possible that a significant portion of these purchases are improper, unauthorized purchases by minors. Future restrictions should limit them.
On 26 March 2014, King Digital Entertainment (NYSE:KING) completed a relatively disappointing initial public offering. The IPO, which raised about $500 million, valued KING at slightly over $7 billion. This valuation is slightly greater than the 2011 IPO valuation of Zynga (NASDAQ:ZNGA), which is seen by many as the most comparable peer in the business of mobile and social gaming. Some investors may be wary of KING, for fear that it may decline to the extent that ZNGA did just a few months after going public. I believe that there is very good reason to be wary of this KING.
For those that do not know it, or play it, King Digital Entertainment is the maker of Candy Crush Saga, which is one of the most popular applications for smartphones and tablets. King makes numerous other games, with titles totaling over 180, but the vast majority of them will appear to non-players as substantially similar to Candy Crush. Yes, there are some differences from game to game, but the variations are often slight enough to seem like different levels of the same game.
KING's IPO was undeniably less impressive than the plethora of recent digital and mobile IPOs that preceded it, with shares declining by slightly over 15% on the first day. Since then, shares have remained range-bound, with investors and pundits questioning not only whether KING has a future, but also whether the IPO marked the end to a recent era of mobile and/or broad market euphoria. KING is now valued at about $5.8 billion, or roughly 20 percent below its IPO pricing.
Whether the company has one or dozens of games, its valuation seems lofty and its portfolio of games seems non-diverse. This appears especially the case when compared to its peers. Beyond ZNGA, which is now valued at about $3.7 billion, or around 1/3 less than KING, Electronic Arts (NASDAQ:EA) has a market value of about $8.8 billion. Further, EA earns its income from a diverse universe of platforms and genres, including action, racing, shooting and role-playing games, among others, as well as its arsenal of sports games that are likely to perpetually remain in demand. Similarly, Activision Blizzard (NASDAQ:ATVI), which is worth about $13.8 billion, holds a broad portfolio of games that include behemoths such as Call of Duty and World of Warcraft, among many others.
As opposed to games like ATVI's Call of Duty and Warcraft, or EA's Sims, FIFA or Madden franchises, KING's games do not have a significant track record upon which to extrapolate future demand. Moreover, it appears as though mobile gaming has a very low barrier to entry and that games may quickly become trendy, but soon get deposed by another.
KING certainly recognizes its non-diverse revenue base, despite its significant number of titles. In the IPO's prospectus, KING noted that a very small number of games generate a substantial majority of its revenue. In fact, during Q4 of 2013 Candy Crush Saga generated about 78% of the revenue, and its top three titles brought in about 95% of the revenue. Therefore the overwhelming majority of the over 180 titles that KING boasts are at least currently relatively irrelevant.
There is still a generally unrecognized risk that may soon become significant. KING games like Candy Crush and Pet Rescue Saga are initially free-to-play, in that users can download it for free and begin to play the game, with payments occurring only if the player wants to purchase some add-on improvement, extra lives or unlock new levels. Some consider this model to be within the category of 'freemium' software, though KING might disagree with that label.
The free-to-play model has thus far made KING among the highest grossing mobile game makers, but there may be an issue at its core. In particular, though these games are played by individuals of many ages, there can be no doubt that, like all video games, children represent the principal market.
Recently Apple (NASDAQ:AAPL) responded to customer complaints regarding the ease with which children were making in-app purchases by making it easier for parents to control and/or wholly restrict in-app purchases like those upon which KING's business relies. Further, Apple indicated that parents who claim their children made unauthorized purchases might be able to obtain a refund from Apple. See a portion of a recent Apple mass-email regarding in-app purchases (Source: Apple): (click to enlarge)
If Apple's restrictions do reduce the rate at which users make in-app purchases, it could be very harmful to KING's business model. Worse yet, it appears probable that Apple will refund some prior in-app purchases, and it is also entirely within the realm of possibility that this could result in a revenue claw-back from KING. To the extent that Android users complain of similar problems, it may be the case that in-app purchase restrictions will even further constrain future revenue prospects
Over the next few quarters, it appears likely that cracks in KING's business will become increasingly evident, and that its now impressive revenue stream may dry up. This all indicates that, at this time, there is an insufficient margin of safety to support an investment in KING.
Additional disclosure: I intend to buy KING puts on any near-term strength in shares, but I do not expect such strength.