King Digital - Could The Near Capitulation Of Investors Create Opportunities?

Aug.13.14 | About: King Digital (KING)

Summary

King Digital issued a very weak third quarter guidance, while the fourth quarter might see sequential improvements.

The outlook is weak, but the already low valuation and disappointing post-IPO performance has lowered expectations ahead of the report.

After the latest sell-off, appeal might improve with cash holdings building up and diversification efforts progressing well.

Investors in King Digital (BATS:KING) were not pleased at all with the company's second quarter results and the weaker guidance for the remainder of the year in particular.

While I acknowledge the risks related to the lower popularity of the company's flagship game, I do see a very appealing valuation. This is as multiples become easier going forwards and diversification efforts are paying off.

Of course, more difficult days might be ahead especially in a very weak projected third quarter. That being said the company remains very profitable and has demonstrated its first commitment to return cash to investors, guiding for better days in the final quarter of the year.

Second Quarter Results

King Digital posted second quarter sales of $593.6 million, a 30% increase compared to the same period last year. Despite the rise in year-on-year revenues, total sales fell short compared to consensus estimates at $606 million as sales have been falling on a sequential basis.

The company remains incredibly profitable, posting a 31% increase in net earnings to $165.4 million. This results in after-tax margins of nearly 28%. GAAP earnings per share were up by thirteen cents to $0.52 per share.

Non-GAAP earnings came in at $0.59 per share, in line with consensus estimates.

Looking Into The Performance

Of course King's performance has been driven by the success of Candy Crush Saga which was hugely popular but turned the company essentially into a one-trick pony.

The company launched the sequence called Bubble Witch 2 Saga, while acquiring Nonstop Games in Singapore. The company stresses the focus on diversification, having 3 games in the top 10 of best grossing games on platforms like Apple's App store, Google Play's store and Facebook.

Gross bookings for the second quarter came in at $611.1 million, whiles net sales were a bit lower thanks to the sales tax resulting in the vast majority of the discrepancy between bookings and revenues. Gross bookings were down nearly 5% from the $641.1 million reported in the first quarter.

While the number of users growth was very healthy, fewer people sign up to spend real cash in playing the company's games. The number of daily active users increased by 82% to 138 million users, while the number of monthly active users rose by 83% to 485 million.

Growth on a sequential basis which much more limited with monthly active users being up just 1% on a sequential basis while daily active users were down 3% compared to the first quarter.

The shocker was that despite the year-on-year user growth, the number of monthly active paid users rose by just a percent on an annual basis to 10.4 million. More shocking, this number fell by 12% on a sequential basis. Average revenues per user rose by 26% on an annual basis to $19.54, and were up by 8% sequentially.

Lowering The Full Year Outlook

The main pain of the report was the fact that King Digital was forced to lower the full year outlook of the business.

For the current third quarter, gross booking are seen at $500-$525 million which would imply a rather disastrous 16% fall in bookings on a sequential basis.

Given the outlook for full year gross bookings of $2.25 to $2.35 billion this implies that fourth quarter bookings are seen around $500-$580 million. This shows that the company anticipates a healthy sequential improvement in the fourth quarter.

The guidance for the third quarter and full year bookings were quite weak in comparison to consensus estimates. Analyst were anticipating third quarter bookings of $614 million and full year bookings of $2.47 billion.

To offset some of the pain inflicted by the lower outlook, the company has announced a $150 million special dividend. Furthermore a very substantial group of shareholders, which combined hold 80% of the shares, have agreed to a lengthening of the lock-up period to at least the release of the fourth quarter results.

Valuation

King Digital ended the quarter with $832.2 million in cash and equivalents while it does not have debt. The proceeds from the public offering and the huge operational cash flows have resulted in this rapid built up in cash holdings.

Given the outlook for $2.3 billion in gross booking, revenues of around $2.2 billion might be attainable. Earnings might seen around $550 million orso, although I agree that these numbers are debatable.

With 318 million shares outstanding, and shares falling to levels of $14 in after-hours trading, equity in the business is valued at $4.5 billion. This values operating assets at around $3.7 billion after backing out the net cash position, valuing operating assets at 1.6 times annual revenues and just 6-7 times earnings.

A Much Anticipated Sell-Off

To say that this decline comes as a surprise is simply dead wrong. Many warned about the high valuation for the one-trick pony at the time of the IPO. That being said, many argued that the valuation at the time already took into account the risks given the already low valuation multiples at the IPO price.

Yet after witnessing a disappointing offering at $22.50 per share, shares are now down nearly 40% compared to the offering level. This move had an even greater impact in the valuation of operating assets given that the net cash position which has only grown over time.

The real strong momentum in the operational business was seen in the third and fourth quarter of last year, as well as the first quarter of this year. Ever since, sales have been softer on a sequential basis, yet as time passes comparables will become easier again, especially after the third quarter.

Final Takeaway

I like the role of time playing the favor of investors in the company. Cash flows are still piling in while the stock continues to be hammered, putting even more pressure on the valuation of the operations.

While the company is guiding for a very soft third quarter, there are some encouraging signs. The main one is the increased diversity of gross bookings away from Candy Crush Saga, which rose by 33% on a sequential basis to $250 million. Non-Candy Crush Sage bookings now make up 41% of total bookings, a ratio which compares to 33% in the first quarter. Another encouraging sign is of course the sequential improvement forecasted in bookings for the fourth quarter.

As such the company is clearly a value player trading at 6-7 times earnings, while the improved diversification is appealing. I also like the move of a nearly $0.47 per share dividend and the lengthening of the lock-up period, restoring some confidence with investors even after the operational disappointments.

I will keep the stock on my radar and if shares might test the $12-13 region in the coming days, which would value shares at just 6 times earnings, I won't hesitant to pick up a small speculative position.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in KING over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.