King Digital Entertainment PLC (BATS:KING) shed about 23% of its stock price on August 13, 2014 after the release of its Q2 2014 results the previous day, which missed analyst expectations in both revenue and net profit numbers. The stock has since failed to rally past the $14 mark, as investors continue to question the potential of its standout social game, Candy Crush Saga.
Q2 misses by a whisker, but a sequential slowdown triggers meltdown
However, not everything came out worse in King Digital's Q2 results. For instance, gross bookings for the June quarter were $611.1 million, up 27% over the revenue in Q2013. The EPS was $0.59 against analyst estimates of $0.60, thereby missing by just $0.01. The company's most popular game Candy Crush along with two other games continued to be among the top 10 grossing games in the market with 75% of gross bookings coming from the mobile platform.
Now, while the company's gross bookings improved year-over-year, the sequential figures posted a decline, which shows waning demand for the company's standout game, Candy Crush. This is most likely, what investors saw from the company's most recent quarter results. The gross bookings declined 5% compared to Q1 2014 while revenue declined 2% for the same comps.
Candy Crush Saga follows FarmVille footsteps
Many analysts now believe that candy crush Saga is past its peak performance, and could possibly follow in the footsteps of Zynga's (NASDAQ:ZNGA) FarmVille, the game it dislodged from the top, consequently adding to the world's leading social gaming company's troubles.
Other performance metrics like Daily Active Users (138 million) was down 3% over Q1 2014 while Monthly Unique Users (345 million) edged down 2% over Q1 2014. The number of monthly unique players was also down 12% compared to Q1 2014 at 10.4 million.
These waning performance metrics have instilled a fear of sudden user base decline and consequent decline in revenues and net profits. User interest can pickup and fade very quickly in interactive games, a case in point being Zynga, which has been struggling since its mid-2012 price crash.
King lowered guidance meaning it understands what's going on
The company also does not seem particularly optimistic for the near future, as it made a downward revision to its Q3 guidance reducing bookings targets to $500 million to $525 million in gross bookings. The company also reduced its estimate for full year 2014 to $2.25 billion to $2.35 billion.
The muted guidance together with the uninspiring results (comparable sequentially) are behind the company's landslide plunge two weeks ago and seem to be culpable for its failure to recover with investors keeping a watchful eye on the developments in MAUs and bookings.
A Special dividend fails to cheer up investors, but margins offer hope
The company announced a special dividend of $150 million to boost investor confidence, but judging by current price levels, it has failed to spike any optimism as the stock remains pinned below $14 per share. This further suggests that investors are more interested in the company's long-term view rather than cashing on a quick dividend.
Nonetheless, King Digital could still shift up a gear, if investors can bet on its improving margins. The company reported an improved EBITDA margin of 42% in Q2 2014 (vs 40% last year) while cash balance remained strong at $800 million.
What does King Digital need?
Strategically the company needs another blockbuster game like Candy Crush to fill the void after Candy Crush loses steam. That is the general view, a like for like replacement, all be it a different game. However, that will just be another faddish title, likely to wane in a few quarters, just like its predecessor. Therefore, King Digital must find redefine its business strategy.
The company is introducing new games like Bubble Witch 2 and hasacquired Singapore based Non Stop Games to develop new genre of games. The acquisition strikes me more, as it seems likely to help Kind Digital change its business strategy.
More importantly, this opens avenues for the company to develop games that could prove crucial in building attachment with players. Developing games that can create user attachment means prolonged lifespan for the various titles. Character games tend to well when it comes to user attachment, so perhaps this could be another answer to Kind Digitals waning popularity of titles.
Meanwhile, King Digital could also gain some short-term resurgence following its breakthrough in China. Candy Crush, which launched in China last month, seems to have created a new source of gamers for the company's titles. Candy Crush now appears set to add more users and improve the user performance metrics.
Though the overall sentiment has turned negative, from a relative valuation point of view based on multiples, investors seem to have overreacted on recent results, thereby sending the stock plunging to incredible levels. The stock before the announcement of Q2 2014 results was trading at a P/E multiple of 9x its trailing EPS of $2.01.
After the slump, the current P/E multiple has reduced to 6.88x making the stock look slightly cheaper. Furthermore, analysts are estimating year-end EPS at $2.13 for 2014, the target price at current valuations is at least $14.65, which means that the stock currently appears optimally valued.
However, if the company does not miss analyst estimates in the next two quarters, then this could help raise the valuation multiple as investors begin to grow in optimism. Additionally, the company's current valuation multiple in P/E is ridiculously low compared to the industry average of 31x.
The bottom line is that King Digital is currently suffering from a post-earnings investor reaction, which means despite the obvious warnings signs on MAUs and revenues/earnings, a part of the current stock price decline is event driven, and the sooner investors realize this then the stock could easily shift up a gear for a marginal recovery. Good results in the coming quarters could be source of renewed optimism for investors.
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