Should You Jump on King Digital?

Investors remain wary following the Zynga fallout, but given the conservative valuation, King Digital might actually be a buy!

Mar 27, 2014 at 2:30PM

Investors got burned with Zynga (NASDAQ:ZNGA), and as a result, they were very cautious of King Digital's (NYSE:KING) IPO. And while valuations within the online gaming space in companies like Zynga and in well-established gaming companies such as Activision Blizzard (NASDAQ:ATVI) vary, King might have in fact left significant gains on the table following its IPO.

King: Not like Zynga
By now, the rise and fall of Zynga and its Farmville franchise is well documented, as its stock fell from $15 to a low of $2.50 in less than one year. Furthermore, the company's revenue peaked in 2012 at almost $1.3 billion, and last year, it dropped significantly to $873 million, and it doesn't appear to be slowing as the company continues to cut costs dramatically.

So, investors are scared that King will be a repeat of history. However, there are a few key differences worth noting.

First, pre-IPO talks surrounding King had its valuation pegged at $10 billion, but with its stock falling 15.5% and pricing below the expected price, its valuation now sits at $6 billion. In comparison, that's 50% greater than Zynga's current market capitalization.

However, there's a key difference between these two companies: King has $1.98 billion in net bookings for the last year and $567.6 million in net income, both of which are far higher than anything Zynga ever created. With that said, Candy Crush is 80% of King's total bookings, meaning it's very reminiscent of Farmville's impact on Zynga.

The fact that Candy Crush is much larger than Farmville at its peak, and is primarily played on mobile phones versus Facebook, suggests that its bookings may not fall as drastically as Farmville. Nonetheless, King is not priced for perfection, and based on what we know now about Candy Crush, King might in fact trade higher in the future.

Priced for gains
For investors in the gaming space, most would consider Zynga the sleeping giant, or a company that's one blockbuster shy of large gains. Then, there's Activision Blizzard, the quintessential juggernaut in the gaming space as a whole. The remaining industry fits somewhere in the middle.

Zynga trades at nearly five times sales, and with an operating margin of negative 6.3%, it is far from profitable. Also, let's not discount its 43% year-over-year revenue loss in its fourth quarter, which also plays a role in its valuation.

Activision has $4.5 billion in annual sales, which includes two billion-dollar franchises and a new game called Destiny that many expect to become the company's third blockbuster. Hence, with a $15 billion valuation, it is not uncommon that large sums of revenue come from one, two, or sometimes three individual games/franchises. Yet, for Activision's consistency, and for the leader of the gaming pack, it trades at 21 times earnings and a price/sales ratio of 3.2.

Now, with the valuations and multiples of Activision and Zynga in mind, King, a company that grew 11-fold last year, is trading at three times sales and 10 times earnings following its IPO. Based on Wall Street's valuation of its peers, King is trading at a significant discount to the overall space.

Final thoughts
King might never grow to become the next Activision, but with its current fundamentals, and valuation, it is unlikely to relive the misery of Zynga. At Zynga's peak, it was a $13 billion company, trading at 10 times sales. Yet, even at Zynga's best, it still wasn't profitable, and it was far smaller than King is today. Hence, King is better, bigger, and more profitable -- with a profit margin of over 25% -- than Zynga was in its best days. With that said, King looks to be presenting a pretty good opportunity right now, and with very little risk following its IPO.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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