Why King Digital's IPO Was a Dud

King Digital Entertainment saw its shares decline during its IPO, and with most of its revenue coming from a single game, the potential for an eventual earnings meltdown is high. King is in a difficult spot, and becoming a stable, sustainable, diversified business will not be easy.

Mar 31, 2014 at 1:00PM

King Digital Entertainment (NYSE:KING), the company behind the outrageously popular mobile game Candy Crush Saga, failed to achieve the same popularity with investors when it IPO'd on March 26. The stock declined from its initial offering price of $22.50 per share, and by the end of the week shares of King were down nearly 20%. I warned about King's IPO in a previous article, with a lack of diversification and intense competition being my main concerns. It seems that the market had the same idea. Here's why King's IPO was a dud, and why the company's stock should be avoided.

A different kind of IPO
More often than not, tech IPOs feature companies with rapid revenue growth and large losses. King is actually the exact opposite, though. King earned $567 million on $1.9 billion in revenue in 2013, and the market capitalization at the IPO price of about $7 billion puts the P/E ratio at just 12.3. It's even lower now that the company's stock has dropped, and it may seem tempting to invest in King given that the company grew its revenue by a factor 10 last year. That kind of growth, coupled with a reasonable P/E ratio, seems too good to be true.

Well, it is too good to be true. King's meteoric growth in 2013 was largely due to a single game, Candy Crush Saga. Each day, nearly 100 million users play over 1 billion games, and about 78% of the company's revenue comes from just this single game. The next most popular game that King offers, Pet Rescue Saga, has only about 15 million daily users.

This poses a big problem for King going forward. Inevitably, the popularity of Candy Crush is going to decline, much like every other free-to-play mobile game that became extremely popular at one time or another. Zynga (NASDAQ:ZNGA), another free-to-play game company, has suffered a similar fate, with games like Words with Friends and Draw Something well past their respective peaks.

Google Trends offers a way to measure the popularity of these games over time, and although web search volume is a far from perfect metric, the results bode poorly for King.

King Trends

Source: Google Trends

This graph shows the relative search volume for Angry Birds, a game from privately owned Rovio Entertainment, Words with Friends and Draw Something, once popular games from Zynga, and King's Candy Crush Saga, where I used the search term Candy Crush.

Interest in Candy Crush has already started to decline, and this decline mirrors that of the other once-popular games. Angry Birds has managed to remain relevant, although still well below its peak popularity, partly because it's been turned into a franchise with many different games. Candy Crush doesn't appear to have that same potential, however. My conclusion from this graph is that Candy Crush is already well past its peak, and the only question remaining is how fast the game declines.

King has two options. The first is to release a game that matches Candy Crush's popularity, a feat easier said than done given the enormous amount of competition in the free-to-play games market. The second option is to make acquisitions, but this can be a dangerous path to follow. Zynga has spent quite a bit of money on acquisitions in the past, and the results have not been great. The company spent nearly $200 million on OMGPOP, the developer behind Draw Something, at about the same time the game peaked. Zynga later shut down the studio.

Earlier this year, Zynga spent $527 million on another acquisition, Natural Motion, and I expect the results to be similar to the OMGPOP debacle. King needs to avoid the trap that Zynga fell into, overpaying in an act of desperation, and that will be difficult. As it stands, I can't imagine King growing its earnings this year compared to last year without a major new hit. While the company is flush with cash after its IPO, the potential to waste that cash is great.

The bottom line
King is a one-hit wonder at this point, and its one hit is already in decline. Zynga offers a template of what not to do, but King is going to have a difficult time diversifying without making expensive acquisitions. In the ultra-competitive free-to-play games market, King has no advantages, and with future earnings impossible to predict, it's best to simply stay away from the company's stock.

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Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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