On the surface, King Digital's (NYSE:KING) first quarter seems solid. On a year-over-year basis, revenue nearly tripled and EPS more than doubled, driven by the company's most successful game, Candy Crush Saga. But Candy Crush has started to decline, and the biggest concern going into the company's recent IPO was a severe lack of diversification.
While the picture has improved a bit during the first quarter, King still has a serious problem weighing on its future. If the history of Zynga (NASDAQ:ZNGA) is any indication, King's glory days may be behind it.
Stagnant revenue, falling profit
While both revenue and profit grew substantially compared to the same quarter last year, when compared to the previous quarter, the story is very different. Revenue grew by just 1% sequentially, essentially flat, as the decline of Candy Crush was offset by growth in other games. Candy Crush now makes up 67% of gross bookings, down from a higher 78% in the previous quarter.
There's good news and bad news here. The good news is that King is becoming decreasingly reliant on a single game, with non-Candy Crush games now accounting for a third of gross bookings. The bad news is that this increase in diversification was achieved by Candy Crush declining.
More bad news is that net profit decreased by 20% compared to the previous quarter, driven by an increase in costs related to both marketing and share-based compensation.
Why higher spending is in King's future
The decline in King's profits isn't really that surprising. The company is transitioning from depending on a single game for most of its revenue to depending on many games, and this means more employees and higher costs. King opened its seventh studio during the first quarter, located in Berlin, Germany, and Farm Heroes Saga, launched in January, was the fifth mobile game released by the company in 18 months.
Constantly churning out new games, necessary to offset the decline in Candy Crush, has led to significantly higher costs. Year over year, total costs have increased faster than total revenue, driven by an 11-fold increase in general and administrative costs and a 2.7-times increase in sales and marketing expenses.
Without another ultra-popular hit like Candy Crush, margins are never going to be as high as they were during the peak popularity of the game. And if new games continue to simply cancel out the Candy Crush decline, then profits are going nowhere anytime soon.
TV commercials? Really?
With the company now spending money to air TV commercial for Candy Crush Saga, investors may want to ask themselves if TV is really the best way for King to spend advertising dollars. We are talking about mobile, free-to-play games here. King broadened its TV advertising efforts during the first quarter, and it now airs commercials in 24 countries around the world.
It seems that TV is not the most cost-effective way to advertise a mobile game. King appears to be spending heavily on advertising in a desperate attempt to slow the decline of Candy Crush.
King has plenty of cash lying around -- $678 million at the end of the first quarter. So it can certainly afford it. But King is falling into the same trap that Zynga fell into, although it's manifesting itself in different ways. Zynga, faced with a failing business model and $1.8 billion at its peak in 2011, made a couple of expensive acquisitions that didn't help turn around the company's fortunes. It spent $200 million in 2012 on acquisitions, and nearly $400 million was spent during the first quarter of this year on U.K.-based Natural Motion. The company has started to turn itself around under new management, but losses are still piling up. Zynga lost $61 million in the first quarter on $168 million in revenue, and while the company has enough cash to survive for a long time, right now its business model simply isn't working.
King hasn't made any big acquisitions yet, but the TV advertising seems to be another case of spending money because it's there.
The bottom line
King is spending heavily on questionable advertising as it tries to counteract the decline of Candy Crush, but much like Zynga's big acquisitions, this seems to be a substantial waste of money. Growing profits going forward will be difficult as King expands its operations in order to churn out enough games to keep revenue growing. Adding to the difficulty is the level of competition in the free-to-play mobile games market. Shares of King may look reasonable based on current earnings, but it's the future that matters, and the future doesn't look good.
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.