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IPO Watch: Don't Get "Candy-Crushed" by This Growth Story

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Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

U.S. stocks were little changed on Tuesday, with the benchmark S&P 500 index down gaining just 0.12%. Nevertheless, it has now crept back to within a half a percentage point of the all-time closing high it achieved on Jan. 15. The narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) fell 0.15%.

Last time, I highlighted Swedish online streaming service Spotify, as it moves toward a U.S. stock market listing. Today, London-based casual game developer King Digital Entertainment, which owns the highly successful Candy Crush Saga, filed with the U.S. Securities and Exchange Commission for a $500 million initial public offering on the New York Stock Exchange.

Given the returns that have accrued to investors that were able to participate in the listings of Facebook and Twitter, the market is very receptive to growth stories, particularly those that tie in to social networking or mobile devices. However, before flocking to own a piece of King Digital, I would suggest investors consider instead the case of its closest publicly traded peer, Zynga (NASDAQ: ZNGA  ) , the shares of which have lost nearly half their value relative to the $10 IPO price and nearly two-thirds compared to their all-time high.

For growth addicts, some of King Digital's headline numbers certainly provide the necessary enticements. Take its flagship title, Candy Crush Saga, for example: 93 million daily users play the game nearly 1.1 billion times every day. Fourth-quarter revenue rose to $602 million from $70 million in the year-ago quarter, while quarterly profits shot up from $6 million to $159 million over the same period.

King Digital doesn't rely on an advertising model; instead, it seeks to attract a wide audience by making its games free-to-play and then giving users the option to purchase in-game "virtual items" (at a unit cost of $1, typically). These purchases are made through four main platforms (Apple's iOS, Google's Android, Amazon's Kindle and Facebook), for which the platforms collect a whopping 30% of the after-tax payments made to King Digital. Its reliance on these platforms is a risk factor (as highlighted in its registration document), but it's far from the only one.

Consider the company's dependency on a small number of titles. Although, King Digital has developed 180 games, its top three games account for 95% of total gross bookings, with Candy Crush Saga alone accounting for 78%. Anyone who has even the slightest inclination toward buying King Digital shares ought to ask themselves a couple of simple questions -- which are very difficult to answer:

  • How many people who are playing Candy Crush Saga today will still be playing the game one year, three years, or five years from now?
  • As Candy Crush's popularity declines (as it inevitably will), what are the odds that King Digital will be able to replace it with an equally popular title?

With regard to the second question, some of the numbers King Digital provides provide some useful context that shows that game popularity does not follow a nice, smooth distribution. We've seen that three of 180 games account for nearly all of the company's revenues, and the drop-off between Candy Crush Saga and the number two game, Pet Rescue Saga, is enormous (1,085 million daily game plays versus 129 million daily game plays.)

These are "winner-take-all economics" with the winners few and far between (and difficult to predict at the outset.) Furthermore, King Digital itself warns that "there are low barriers to entry in the digital gaming industry, and competition is intense."

King Digital Entertainment faces the very same challenges as Zynga: It operates in an industry with low barriers to entry and caters to an audience with a short attention span and fickle tastes, resulting in products with a limited shelf life. Punting on over-hyped growth company IPOs is itself an addictive game; when it comes to King Digital Entertainment, I suggest investors kick the habit.

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Alex Dumortier

Alex Dumortier covers daily market activity from a contrarian, value-oriented perspective. He has been writing for the Motley Fool since 2006.

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