Do Your Homework Before Buying Into the King IPO Hype

The maker of "Candy Crush" is set for an IPO next week, but questions remain whether investors will be well-served by buying into the IPO hype.

Mar 24, 2014 at 9:00PM

King Digital Entertainment is set to go public with the ticker "KING." The maker of the wildly popular Candy Crush Saga is the latest to take advantage of a hot IPO market; management is seeking an IPO price of up to $24 per share, which translates into a valuation of almost $8 billion. Given the recent track record of the IPO market, shares that become available to the public after trading commences will likely command a premium on top of $24 per share. Investors must determine if this valuation is reasonable.

Competitive landscape
King operates in the highly competitive field of video game development, which is occupied by a wide range of video game developers including Activision Blizzard (NASDAQ: ATVI), Electronic Arts (NASDAQ:EA)Take-Two Interactive (NASDAQ:TTWO), and Zynga (NASDAQ:ZNGA). Below is a quick comparison of these companies to King based on the company's recent SEC filing:

Market capitalization (in billions) $7.6 $14.9 $9.4 $1.8 $4.5
TTM price to sales ratio 4.0 3.3 2.6 0.8 5.1
TTM price to earnings ratio 13.4 22.0 N/A 5.8 N/A

Source: Yahoo! Finance-March 20, 2014
* King valuation and multiples based on share price of $24 and information from Form F-1 filed with the SEC.

To put this in context, the table above projects a valuation for King that is more four times as much as Take-Two. Is this sizable valuation justified?

The bullish argument
Investors eagerly awaiting the King IPO are often looking at two simple concepts. First, King's revenue growth has exploded, from more than 1,000% from just $164 million in revenue in 2012 to $1.88 billion in 2013. Very few businesses can ever produce growth of that magnitude, so credit is due to management for accomplishing such an impressive growth rate.

Second, King is quite profitable. The company generated $568 million in net income in 2013 and free cash flow of $657 million. Both measures justify a $24-per-share valuation with a very reasonable trailing P/E ratio of 13 and free cash flow yield of almost 9%. 

With this growth and valuation combination, many may wonder whether King's shares will spike much higher after the company makes its debut. It is possible, but before jumping on the bandwagon there are several risks to consider.

Risks to the investment thesis
EA was the preeminent developer 20 years ago, yet the company's stock has sagged in recent years due to profitability struggles. Zynga, a mobile-focused developer that created a similar buzz to the King IPO, fell flat due to its inability to monetize "freemium" games. Take-Two, which has the lowest P/E ratio in the table above, has also struggled to remain profitable, despite having a broad assortment of titles. Several years of losses were reported before 2013's strong earnings. These struggles have translated to weak share performance over the past several years:

EA Chart

All three companies have failed to beat the market since Zynga's highly anticipated IPO in late 2011.

Video game developers' inconsistent performance should be especially alarming to potential King shareholders. While the company currently has the second, fourth, and sixth top-grossing games on the iOS App Store, the company has only monetized one type of game. These top selling titles, Candy Crush Saga, Farm Heroes Saga, and Pet Rescue Saga, are all variations on the same concept, as are several other King games.

In King's F-1 filing, it notes that 95% of total gross bookings come from these three games. So, until King demonstrates the ability to develop other successful franchises, an investment in the company is a wager that Candy Crush will drive results for the foreseeable future. 

There are already signs that point to the beginning of a decline in King's Saga popularity, with App Store downloads of its big three titles dropping to the 10th, 14th, and 41st spots on the charts. Whether it is Flappy Birds or whatever comes next, there hasn't been a great track record of mobile apps staying popular for long.

Best of the video game developers
Rather than speculate on the duration of Candy Crush's popularity, or whether King can develop a second winning concept, it makes more sense to pick a video game developer that already has a long track record of profitability, several franchises that have reached $1 billion in revenue, and a rich pipeline.

This company is Activision Blizzard. Unlike its peers, Activision Blizzard has been consistently profitable and has demonstrated the stability of its business model by regularly returning value to shareholders via dividend and share repurchases. While Activision Blizzard is making a push into mobile in 2014, the company has a stable revenue base from leading console titles like the Call of Duty series as well as subscription revenue from games such as World of Warcraft. Investors also can look forward to a pipeline in 2014 that includes Destiny, a title that management expects to reach $1 billion in revenue. 

Even though shares of Activision have almost doubled since I first declared 2013 to be "the year of the Activision breakout," the market still hasn't quite appreciated just how solid and consistent of a business it is. As a result, there remains upside from investing in the best-in-class company in video game development rather than speculating on the flashy newcomer that carries significant risk.

If you could only pick one stock this year, this should be it
There's a huge difference between a good stock and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Brian Shaw owns shares of Activision Blizzard. The Motley Fool recommends Activision Blizzard and Take-Two Interactive. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information