I just realized it’s been two months since my last post! I have been keeping busy both in and out of the office, but with things finally showing signs of slowing down, I’m glad that I’m able to get back to one of the things I love.
As most of you probably know by now, I have been a critic of what I dub Tech Bubble 2.0, or what I perceive to be the sky high valuation of social media and other tech companies/start-ups in the current economic environment. I gave Facebook and Twitter a pretty big bashing back in November, so you can imagine my shock (or perhaps delight) when I found out that King Digital Entertainment (KING), the creator of the wildly popular puzzle game Candy Crush Saga, would be going public in a transaction that would value the company at an astounding $7.1 billion.
On the very first day of trading (Wednesday 3/26/14) KING dropped 15.6% from its opening price of $22.50 to close at $19.00. The company fell another 2.7% to $18.49 on Thursday, followed by a 2.2% slump on Friday to close out the week at $18.08, or an overall decline of 19.6% since its IPO. It would seem that the equity markets have gotten a little wiser since the Twitter craze, but despite the beating that it has received in its first few days as a public company, I still believe KING is overvalued. Here are three main reasons why I am so bearish on the company:
1. The Company is essentially a one-hit wonder.
Take a look at the last four quarters of KING’s performance. Impressive, right?
Here’s what the charts don’t tell you:
- Candy Crush Saga accounts for 78% of the Company’s total gross bookings, as well as 69% of Daily Average Users (DAUs) and 74% of Daily Game Plays (DGPs). The Company’s top 3 games account for 95% of total gross bookings, but Candy Crush Saga is about five times more popular than its next two games, Farm Heroes Saga and Pet Rescue Saga.
- KING was founded in 2003. Candy Crush Saga was launched in April 2012.
The proverb “don’t put all your eggs in one basket” is quite appropriate when it comes to KING and mobile gaming in general. The potential risks of having the majority of your revenue driven by one source is quite clear – if that revenue source becomes impaired or disappears, you’re in serious trouble. The bad news for KING is that there is evidence that this is already happening. As the charts above show, while the Company’s quarterly average DAUs and MAUs are still increasing, the number of Monthly Unique Payers (MUPs) actually decreased meaningfully in the fourth quarter of 2013. Given the 99.8% correlation between the number of MUPs and Revenue performance, it is not surprising that Revenue also declined in the fourth quarter.
Returning to the fact that Candy Crush Saga accounts for roughly 80% of KING’s top line, one can conclude that a major factor behind the the decline in MUPs and Revenue is the shrinking popularity of the Company’s most popular title.
This brings us to the second bullet point. The fact that it took KING nearly ten years to come up with a megahit highlights the extreme difficulty of developing a game that appeals to a wide audience and that people are actually willing to spend money on. As Candy Crush Saga loses popularity, the chances that KING can develop a game that is equally successful or even half as successful to be its successor are slim. Even if it does manage to achieve this feat, investors need to ask themselves how long this would take. 5 years? 10 years? Longer?
2. The Company has limited means of improving its ability to monetize its user base.
When the vast majority of a company’s business is driven by online and mobile users, the challenge is two-fold: (1) building up the user base and (2) monetizing the user base in a sustainable way. While KING has demonstrated the ability to do the former, it is largely reliant on the “freemium” model to monetize its user base, where users can play for free but are incentivized to make in-game purchases in order to improve their results or improve their gaming experience. While the freemium model is a tried and true method of generating revenue, it has virtually no power to prevent an user from leaving (and stop paying) if he/she becomes uninterested in the game itself. This is where Facebook and Twitter hold a crucial advantage over companies like KING; by serving as platforms for other apps and services (try to think of all the apps/services you use on a daily basis that are connected to Facebook), these social media giants make it very difficult for users to leave their networks.
As seen from the above the charts, while a highly successful product can help increase your user base almost exponentially, improving your ability to monetize on that user base (measured here by Gross Average Bookings per User and Monthly Gross Average Bookings per Paying User) is another story entirely. While KING’s ability to monetize has largely held steady (with fluctuations from quarter to quarter), there is no indication that the Company will actually be able to improve on this ability in a meaningful way in the long-run. Without this ability, revenue growth becomes almost solely dependent on (paying) user base expansion, and given KING’s reliance on its Candy Crush Saga title, we once again find ourselves asking whether the Company can repeat its past success.
3. The Company does not have an economic moat.
Warren Buffett once said, “In business, I look for economic castles protected by unbreachable ‘moats’.” What Buffett means by “moat” is a sustainable competitive advantage that allows a business to maintain its profitability over the long-run.
It is hard to argue that KING or any of its competitors in the online and mobile gaming market have a substantial competitive advantage. From FarmVille to Words with Friends to Candy Crush Saga to Flappy Bird, it is impossible to tell where the next megahit game will come from. While KING can devote resources and personnel to increase the chances of its own success, it cannot prevent thousands of other game developers from doing the same thing.
So what’s it worth?
For a company like KING, the biggest driver of valuation is growth. Given the strong correlation between the number of Monthly Unique Payers and Revenue performance, we set out to project the number MUPs on a quarterly basis from 2014 to 2017.
We start with the number of Monthly Unique Users (MUUs), which has been growing, albeit at a slowing pace. This is likely due to the fact that there is a market penetration ceiling that KING is approaching. According to eMarketer, the number of smartphone users is expected to hit 1.75 billion in 2014 and 2.5 billion in 2017.
If we assume that KING can reach a quarter of those users, that gives us an approximate market of between 438 million and 625 million unique users over the next few years.
In the base case, let’s assume that KING is unable to develop anything that rivals the popularity of Candy Crush Saga. Quarterly average MUU growth, which is already showing signs of slowing down, is likely to slow further. In my model, I have the number of MUUs reaching 395 million by the end of 2014, and increasing by 10 million every quarter thereafter. In terms of KING’s monetization percentage, which I define as MUPs/MUUs, the Company managed to achieve a 5.3% monetization percentage in Q2-13, although that figure fell to 4.8% in Q3-13 and 4% in Q4-13. I believe this percentage will continue to decline in future quarters. If we look at the historical levels, it seems likely that the Company’s recent out-performance in this category in the last 4-6 quarters is driven by the success of Candy Crush Saga. Thus, on a going-forward basis, I have this percentage dropping and eventually holding at 2.5%. What all this results in is a near term decline in the number of MUPs (as the popularity of Candy Crush Saga declines), followed by a slow reversal starting in the middle of 2015 (as the Company continues to develop smaller hits in the future). The last step is linking the projection of MUPs to Revenue growth, which I do through a simple regression in Excel.
In the downside case, I simply apply a 10% haircut to the Revenue growth figures in the base case. Finally in the upside case, I assume KING manages to develop another Candy Crush Saga-esque megahit, leading to triple-digit Revenue growth in the immediate future.
I attribute probabilities of 50%, 40%, and 10% to the base, downside, and upside cases, respectively. For those of you who think I’m being too conservative in my upside case, I think there are two important takeaways here:
- KING’s ability to penetrate the market is limited by the overall number of smartphone users, and the percentage of those users who will play its games. Even if the Company is able to develop one or two more Candy Crush Sagas in the near future, the number of MUUs is constrained. We could, of course, assume that the Company is able to achieve significant gains in its monetization percentage, but even if the Company is able to do so…
- The likelihood of the upside case even happening is too low that its impact on our overall projections is muted.
My final Revenue model is a simply a weighted average of the three scenarios:
Doing a quick-and-dirty projection of unlevered free cash flows and taking a discount rate of 15%, I get to a valuation figure of $2.3 billion.
While there is still a lot of uncertainty in our model, the bottom line is that it would take an inordinate amount of optimism to arrive at a $7.1 billion valuation, or a even a $5 billion valuation.
Before I sign off, I will leave you with another interesting snapshot:
Those are not the financials of KING, but Zynga (ZNGA), the creators of FarmVille. Coincidentally, ZNGA also had a $7 billion valuation when it went public in 2011, but has since lost over half of its value. I think the 5-year summary financials do a pretty good job of telling the moral of the story: in the ever-changing world of social media and mobile/internet gaming, growth (and “value”) can disappear just as quickly as it appeared.
KING shareholders, beware.
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Acknowledgements: Thanks to Michael Lai for his insight on looking at KING’s growth from a top-down rather than a bottom-up perspective.