The upside is not reflected in King Digital
I added a new position in King Digital Entertainment (KING) this week.
I discovered the company while perusing through 13-F filings. I search for hedge funds that have performed well in the last few years and look for tickers of either large or growing positions in those funds. I found King via a fund called Steadfast Advisors.
King Digital is out of my usual area of competence. The company is a video game developer and I have never invested in a video game developer before. I’m not much of a gamer. Nevertheless the company is extremely well-priced for scenarios outside of a collapse of the business, and I am an avid opportunist of market inefficiencies.
King is also a busted IPO. The stock priced at $22 in March and is now $16. The timing of the IPO was bad, both in terms of the market and the business. It was a bad time for the market because tech has taken a pounding. It was a bad time for the business because the biggest grossing game (by far) in the history of the company, Candy Crush, was beginning to go into decline.
See the table below for Candy Crush bookings over its meteoric rise and fall.
(Note that the company did not break down bookings by quarter for the first three quarters of 2013 so I have assumed the 9 month average was constant for all three quarters)
The question that the market has been weighing is whether King Digital is a one-hit wonder. The answer baked into the share price is yes.
The company trades at about 7x the last quarters free cash flow. This is a low capital expenditure, low fixed asset business. There’s no way it would trade at such a low multiple if there was perceived stability going forward.
Yet I don’t think a stunning spiral ala Zynga is a certain outcome. I’ll admit that there’s a great deal of uncertainty around the stock; for one they are in the gaming business, which is a particularly fickle, trend based consumer market that can change quickly. As well King’s history is so short and its growth so explosive that a historical analogy or extrapolation is not available. Yet at the current price the market is not making you pay for success even though a successful conclusion is quite possible. I think that divergence is an opportunity.
Let’s look at what King Digital has going for it.
- They have Candy Crush, which is expected to have a long tail of bookings, is still growing its active users, and has a brand from which multiple spin-offs titles can be created. Already a sister title is expected to be announced in the second half of the year.
- I think the market is underestimating the barrier to entry around marketing – there are a ton of games being added to the mobile stores. To be noticed you need to spend big bucks on advertising, which King has. They also have a brand awareness created by Candy Crush, and they have a network of over 300 million users that can be cross-sold and leaned on to create virality (term that means ability for a game to go viral).
- King has demonstrated, by their success both before, during and after Candy Crush, that they have the people and the process to churn out successful titles.
- While the market is not pricing in success for Farm Heroes or for Diamond Diggers both of these games are showing that they are successful. Farm Heroes in particular is in the top 5 games on Google-play and iTunes and is #2 behind Candy Crush on Facebook, the first platform that it was released on (in the second quarter of 2013). In the table I presented earlier, note that non-Candy Crush growth in bookings has been very strong the last two quarters, which can be mostly attributed to Farm Heroes.
- The company is is just starting to move onto Korean and Chinese platforms and is working to improve brand awareness in Europe. Currently their user base is concentrated in North America. There is plenty of room to build out their user network further.
The bear case for King Digital, which revolves around the decline of Candy Crush, can be summarized as follows:
- Bookings for Candy Crush were down 13% in Q1 after being down 9% in Q4. Maybe Candy Crush is going along a faster decline curve than expected.
- King’s average spend per paying user is over $17. That is very high – somewhere around $2 – $3 per paying user is typical for mobile games. The argument is that this is an aberration brought on by a singularly popular game and King will not be able to monetize users as easily in future titles.
- Paying users are 3.5% of its total user base – that is much higher than most freeium game producers. So the question is whether Candy Crush was unique in its ability to create paying users and they won’t be able to replicate that.
- All of King’s games are the similar. Users will tire of the redundancy
- When the IPO lock-up period ends shares will be sold putting further downward pressure on the stock
I can find elements of both the bear case and the bull case that I sympathize with. The tricky thing about King is that the future is going to depend mostly on the people, the culture and the company’s process, which is not something that is easily evaluated. So far I would say that the empirical evidence (the games) leans toward the bull case, while the stock price is firmly entrenched in the bear case.
I like that dichotomy. There is a reasonable chance that King Digital is able to pull this off. They build off of their Candy Crush franchise, create a 2 or 3 more games that while singularly may not reach the popularity of Candy Crush, add some Candy Crush sequels and sister games, and together all of this is able to sustain and grow the business. If that comes to pass, and the company continues to generate $600 million plus free cash flow and shows it can even grow that number, the stock has to go much higher than it is right now. I took a position in the stock last week around $16.