PrivCo analyst Matthew Turlip considers King Digital Entertainment (KING) — maker of the uber-hot mobile game Candy Crush Saga — to be a “one-trick pony” much like Zynga (ZNGA).
Turlip sees a very rocky future, and so far, he’s right. On Tuesday, KING stock was priced at $22.50 for its IPO, and it’s noticeably down during its first two days of trading.
So, point to Turlip.
But he’s still dead wrong about it being another Zynga. Here’s why:
#1: KING Stock Vs. ZNGA: Research and Development
In the three years leading up to the Zynga IPO in December 2011, ZNGA spent $213 million in research and development to move revenue from $19 million in 2008 to $597 million in 2010.
King? It spent $152 million to boost revenue from $64 million in 2011 to $1.9 billion in 2013. (Also note that King began its climb in 2011 at nearly breakeven compared to ZNGAs $23 million loss from operations in 2008.) Ergo, King was clearly doing a much better job converting R&D into revenue prior to its IPO.
Turlip could argue that King has underspent on R&D, hence why it’s now facing a one-and-done business model. However, the corollary argument is that it’s done a far superior job converting basic R&D into a moneymaking enterprise. Should it come anywhere close in terms of R&D efficiency in future years, KING stock will hit $100 before you know it.
#2: KING Stock Vs. ZNGA: Daily Active Users
ZNGA had 54 million average daily active users (DAUs) when it went public in late 2011. King had 144 million average DAUs in February of this year — 167% more than ZNGA. While Candy Crush Saga accounted for 67% of this number, it has three other games — Pet Rescue Saga, Farm Heroes Saga and Papa Bear Saga — with more than 5 million DAUs each. Most notable is Farm Heroes Saga, which saw DAUs move from an average of 8 million at the end of December to 20 million in February.
As King’s business grew in the seven quarters leading up to its IPO, the company pushed the DAU needle from 11 million in Q2 2012 to 124 million at the end of Q4 2013. Meanwhile, ZNGA’s average DAUs were 67 million in Q1 2010 and 54 million in Q3 2011 just prior to its IPO.
So, while ZNGA users were flatlining leading into its IPO, King users were increasing exponentially.
The fact that Candy Crush was responsible for a good chunk of that growth shouldn’t affect your opinion of KING stock. After all, WD-40 (WDFC) is pretty much a one-trick pony, and its stock has achieved an annualized total return of 29% over the past five years — 11 percentage points higher than the S&P 500.
#3: KING Stock Vs. ZNGA: Valuation
At the time of its IPO, Zynga’s users were flatlining; expenses were rising faster than revenues and its $7 billion IPO valuation came in at 6.4 times sales. In the case of KING stock, we have a firm that’s increasing its DAUs in each successive month, has been able to grow revenues 60% faster than its expenses and possesses an IPO valuation of $7.1 billion (based on $22.50 per share), or 3.7 times revenue.
Today, ZNGA trades at 4.7 times revenue despite losing $65 million before tax. Meanwhile, King’s multiple is less than that despite earning almost three-quarter’s of a billion dollars before tax in 2013.
What strikes me odd about Zynga is that it has over $1 billion in cash and short-term investments, and yet it has repurchased just $21.1 million in ZNGA stock since October 2012 when its board approved a $200 share repurchase program. In that time, ZNGA shares have traded between $2.84 and slightly more than $5. Trading at less than half its IPO price, there could be no better time to send a signal to the markets that good things lie ahead. Clearly, Don Mattrick has his work cut out for him.
Meanwhile, King CEO and founder Riccardo Zacconi has a good problem on his hands: How to create games equally addictive to Candy Crush. This isn’t some Johnny-come-lately outfit. King has been developing free-to-play games since 2003. It’s no overnight success, and that resilience will come in handy when analysts like Turlip second-guess the company’s business model.
The fact remains that King generates revenue from just 4% of its 304 million average monthly unique users (MUU), meaning a 1-percentage-point bump adds $53 million in gross bookings per month (304 million x 0.01 x times $17.32 in monthly gross average bookings per paying user) to its top line. As long as it grows the number of MUUs each quarter by 5%-10% and monthly unique payers (MUPs) above the current 4%, and you quickly realize that the potential for KING stock based on its current valuation is significant.
Bottom Line
Do I think KING stock is a slam dunk? No, of course not — but then, what stock is?
All I know is I’ve been married to my wife for almost 10 years, and I’ve never seen her addicted to anything like Candy Crush Saga. While I doubt she’ll ever pay for the in-game virtual items that are the company’s bread and butter — she’s one of the other 96% — I do think others won’t be so careful.
In the meantime, while King works on converting some of those playing for free, it has time to come up with a game or two that will get my wife into the paying column.
If they do that, we’re not talking about $100 for KING stock. We’re looking at $1,000.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
