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Candy Crush IPO: A Zynga-Like Fiasco Waiting to Happen

By Tim Brugger - Mar 26, 2014 at 2:11PM

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With an even smaller cache of successful online games than its rival, King Digital Entertainment's IPO should be avoided like the plague.

When popular online-game developer Zynga ( ZNGA 3.65% ) went public in December 2011, the company was flying high. Hit games including FarmVille and CityVille generated as much as 12% of Facebook revenues in 2011, as Zynga dominated the social-media king's gaming lineup. The result was what most considered a solid IPO, valuing Zynga at an impressive $7 billion. But those days are long gone for Zynga shareholders, as it struggles to come up with "the next great thing."

One of Zynga's primary competitors, even in the company's own Facebook backyard, is Ireland-based King Digital Entertainment ( KING.DL ), maker of the highly addictive, smash-hit game Candy Crush Saga. King is also the maker of Farm Heroes Saga and Pet Rescue Saga, three of the most popular and "liked" games on Facebook. King  began trading on the NYSE today, pricing its much-anticipated IPO at $22.50 a share, in the middle of its earlier announced range of $21 to $24 a share. The question is: can King avoid a Zynga-like stock price meltdown after the IPO hype dies down?

A few specs
At $22.50 a share for its 22.2 million shares floated today -- with a 30-day option for the offering's underwriters to purchase another 3.33 million -- King is valued at about $7 billion, eerily similar to Zynga's first-day valuation over two years ago.

Some analysts suggest a $7 billion valuation is a fair representation of King's value. Their line of reasoning? King proponents cite last year's $1.9 billion in revenue and $568 million in profit, along with staggering revenue growth of over 1,000% in 2013. Not surprisingly, margins for King's online games are also strong: once it's built and functioning, there's not much needed to keep games chugging along.

Another feather in King's cap is its strong mobile presence, especially compared to Zynga. In 2013's Q4, 73% of King's revenues came from mobile gamers -- an impressive figure, to be sure. But Zynga's mobile lineup is improved after earlier this month announcing three new titles for gamers on the go, including the popular FarmVille 2.

The problems
Like Zynga and others in the online-game industry, King faces the challenge of developing the next great game. That will, and should, always be a concern for investors when considering investing in King, Zynga, or their competitors. For King, the next big hit is even more important since nearly 80% of its revenues, and over 70% of its daily average users, are all derived from Candy Crush Saga. And that staggering revenue growth last year? Candy Crush Saga, what else?

Yes, King has supplanted Zynga at the top of Facebook's list of most popular games, owning three of the top five spots. But the fact remains it's Candy Crush Saga, almost exclusively, driving King's IPO valuation of $7 billion. King's other game titles barely scratch the surface in either revenues or daily average users. For investors that appreciate revenue diversification, King is a nightmare.

King derives its revenues almost entirely through the small number of gamers that actual pay, so revenue growth will come from more gamers electing to pay to play -- and that's it. Ads are an obvious alternative, but King's opted to forgo advertising for the time being. We'll see how long that lasts as shareholders begin clamoring for results in the coming months and years.

Final Foolish thoughts
With a market capitalization of $4.1 billion, Zynga is trading about five times annual revenues. King, on the other hand, is valued about four times sales based on its IPO price of $22.50. That, along with its profits, are what King bulls are hanging their respective hats on. No doubt King is flying high after its record year, so it's an ideal time for an IPO -- if you're a King insider.

Financially, thanks to Candy Crush Saga, King is able to ride its IPO wave to a $7 billion valuation, or more if game-lovers begin a buying spree. But gamers are a fickle lot, and Candy Crush Saga will eventually go the way of Pong; it's inevitable. When it does, King better develop a sound plan B or it'll follow Zynga down the path of share price erosion.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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