King Digital - Uncertainty Prevails After A Hugely Disappointing Public Offering

Apr.23.14 | About: King Digital (KING)

Summary

King Digital's disappointing offering might have just triggered the recent technology stocks correction.

Strong earnings and balance sheet are overshadowed by very disturbing quarterly revenue trends.

Company remains a one-trick pony, unless it can diversify.

King Digital Entertainment (BATS:KING) has seen a very difficult public offering, which took place at the end of March. Some market commentators even attributed the troubled primary offering, combined with some other factors for triggering a sell-off in the so-called "momentum" stocks in March.

While the recent sell-off made shares a bit more appealing, the current valuation still offers no great entry point in terms of risk-reward, in my opinion. I will await the first quarter earnings report to see how the latest trends are unfolding before possibly reconsidering my investment stance.

The Public Offering

King Digital describes itself as a leading interactive entertainment company, of course, best known from its Candy Crush Saga game. While the company offers multiple games, the vast majority of players and revenues are being generated by the Candy Crush game. The game developer attracted a combined 144 million users across all of its games in February of this year. Combined, these users played some 1.4 billion games per day.

King Digital sold 22.2 million shares for $22.50 apiece, thereby raising $500 million in gross proceeds. The company itself sold 15.5 million shares, and thereby raised roughly $350 million in cash for the business. The remainder of the shares were being sold by selling shareholders.

The pricing took place right at the middle of the preliminary offering range of $21-$24 per share, which has been set by the firm and its bankers. Merely 7% of the total shares outstanding were offered in the public offering. Trading at $17.90 per share, based on Tuesday's closing price, King Digital's equity is valued at $5.6 billion.

The major banks that brought the company public were JPMorgan, Bank of America/Merrill Lynch, Credit Suisse, Barclays, Deutsche Bank and RBC Capital Markets, among others.

Valuation

King Digital is focusing on free games in which players can purchase virtual items which are embedded with social features, so they can be seen on social networking communities. Founded in 2003, it has focused on casual games which include a puzzle element, thereby creating a broad appeal. Games can be learned quickly and be played on multiple devices as well. Many of these games were developed to be played on mobile devices as well.

For a long time, the company has been relatively unknown, until Candy Crush Saga became a big hit. The game attracted 1.06 billion active players in February of this year, 97 million of which played the game on a daily basis. Other games which are known by the gaming community are Farm Heroes Saga, Pet Rescue Saga, Papa Pear Saga and the Bubble Witch Saga.

For the year of 2013, King Digital generated revenues of $1.88 billion, which is up from merely $164 million in the year before. This resulted in a profit explosion, as net income rose from merely $7.8 million in 2012 to $567.6 million over the past year.

While growth rates have been spectacular on an annual basis, the first crackdowns in the popularity and revenues of King Digital are already apparent.

Fourth-quarter revenues of $601.7 million are impressive, as they nearly ten-folded on an annual basis. Yet, revenues fell by 3.1% compared to the third quarter of last year. Combined with a continued increase in the cost base, earnings were under pressure. Net income fell from $229.8 million in the third quarter of last year to $159.2 million in the final quarter of that year.

As King Digital already held $409 million in cash ahead of the public offering and has no debt outstanding, the company has a comfortable war chest, while the cash continues to pile in. On top of this come the $350 million in gross proceeds from the public offering, resulting in a net cash position of $700-$750 million.

The $5.5 billion equity valuation therefore values operating assets at roughly $4.8 billion. This values King Digital at merely 2.6 times annual revenues and 8-9 times annual earnings. These very appealing valuation multiples are explained by the significant slowdown in the business momentum. Investors furthermore have bad memories of returns achieved by investing in competing game developer Zynga (NASDAQ:ZNGA) when it first offered shares to the general public.

Investment Thesis

As noted above, the King Digital offering has been a big disappointment. While shares were offered at the midpoint of the preliminary offering range, shares fell on their opening day to just $19 per share. This left investors with a big opening day loss of 15.6%. Shares fell even further to lows of around $16 in the weeks following the offering, before recovering to current levels around $18 per share.

The fall is surprising to some given that King Digital's offering has been priced rather conservatively, at least based on traditional valuation metrics. This compares to the valuation of Zynga at the time that the developer of Farmville saw its initial public offering. Its shares fell sharply after the popularity of Farmville dropped significantly.

It simply appears that King Digital has been a bit too late to file for an offering, as investors were still somewhat shocked to see the quarter-on-quarter decline in fourth-quarter revenues. This is despite sales growing at astronomical rates on an annual basis.

The reason for this is, of course, that King Digital is still a one-trick pony, with over three quarter of its sales being tied to its Candy Crush Saga game. The game's popularity appears to have already peaked in the summer of last year. Therefore, traditional valuation methods are not fair, as growth is inflated, coming from a low base.

Combined with low entry barriers to the business, game developers typically enjoy only short periods of popularity and therefore cash flows from their most popular games.

The slowdown and actual fall in sales are a big concern, yet the build-up in operating costs is another reason to be cautious. The quarterly release, which is planned on May the 7th, will be very important, as it will shed a lot of light on recent developments which will probably not be very encouraging. That being said, expectations of investors have already been seriously lowered ahead of the report.

Despite the recent correction, I still don't have compelling reasons to pick up shares at this discounted level. This is despite the solid operating cash flows and strong balance sheet. I will await the first-quarter earnings release to evaluate the latest trends before possibly reconsidering my investment stance.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.