Analysts and game company CEOs eagerly await King’s initial public offering

The game industry and Wall Street are eagerly awaiting the initial public offering of King Digital Entertainment, which may raise more than $500 million at a $7.6 billion valuation as early as Wednesday.

The West hasn’t seen a major game company IPO since Zynga went public in 2011. And that was a bust after Zynga’s poor financial performance sent its stock downward, dashing the hopes that others would soon follow in its footsteps. If King is successful, it could open the doors for many others to raise money, both in the public and private sectors.

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King made its gargantuan hit Candy Crush Saga with only three game developers. That hit generated a huge chunk of the company’s $1.89 billion in revenue in 2013, and now the company has 665 employees trying to knock out one hit after another. The European mobile and social game maker hopes that investors will buy its story that it will be a hit factory, churning out hits like Candy Crush for years to come.

Chris DeWolfe, the CEO of mobile and social game publisher SGN, said in an interview, “One or two events can have such a large impact on this industry. It’s incredible. The King IPO, everyone is watching that with an eagle eye. If they make the first two or three earnings calls, we’re smooth sailing for another six to nine months. If they stumble, it could have a disastrous effect on investment in our industry.”

Privco’s objections to investing in King

Not everyone is convinced. After first describing King’s user growth as “astonishing,” Privco said on Monday that it advised investors to avoid the King investment because of some major red flags. Privco is a private company-analysis firm headed by Sam Hamadeh, whose pronouncements about upcoming IPOs have often been controversial. But analyzing the numbers that Privco brings up yields some interesting observations for potential investors.

Privco pointed to six major problems that King faces, including the obvious one that King is overly reliant on revenues from a single game whose user base shows signs of a decline. Privco also noted that King’s metrics make its number of users look bigger than it is. It said that management and investors have already cashed out much of their ownership. Privco noted there is very little information on a development pipeline at King, and the risks seem very similar to Zynga’s IPO in 2011, which left investors feeling burned as the stock value fell from $9 billion to under $3 billion (it has now bounced back to $4.5 billion).

Of course, Privco’s stance has to be taken in context. Most of the figures that it cites come directly from King’s March 12 IPO filing document. It’s not like King is hiding these facts. It is pointing out the risks in its own business as it is required to do so by regulators.

Privco notes that 4 percent of King’s monthly unique users (MUUs) are paying customers. (That’s a relatively high percentage compared to some other companies.) The loss of these players could have a big impact on revenues. Privco noted that monthly unique players (MUPs) peaked in the first quarter of 2013 and have declined ever since. The average life span of players is around two to nine months, and Privco says that many of the paying Candy Crush players may soon reach the end of their life span.

“This will be a big risk for King as its business is based on its ability to keep its MUPs engaged,” Privco said.

Privco also said that the way King counts its users, which are based on industry practices, results in an inflated view. The number of monthly average users is 408 million. These include users who are double-counted since they play King games on multiple devices and King does not “de-duplicate” them. The number of monthly unique users (MUU) is only about 304 million. That shows the effects of double counting.

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As for the over-reliance on Candy Crush, Privco noted that 78 percent of gross bookings came from Candy Crush in the fourth quarter. Between December 2013 and February 2014, Candy Crush’s daily active users increased from 93 million to 97 million. That means the growth of the game has dramatically slowed.

Privco also pointed out that management and investors have “cashed out.” In the six months leading up to the IPO, the King board paid $504 million in two separate dividends to management, investors, and other shareholders. King also gave “discretionary bonus units” to shareholders $58 million. Altogether, management, shareholders, and investors will receive cash payments of $621 million without having to sell any shares in the offering. Two other companies that did this prior to their IPOs were Zynga and Groupon.

“King has paid out more in dividends than it will raise in its IPO,” Privco said.

However, King did not point out one of the plain facts in the filing. Riccardo Zacconi, the CEO of King, holds about 10.4 percent of the overall shares of the company before the offering, and he will hold 9.5 percent of the shares after it. So management still owns a sizable chunk, and it truly hasn’t cashed out.

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Privco also says that King hasn’t discussed much about its game pipeline, nor has it described how it is different from the once high-flying Zynga, which crashed after its IPO.

How King operates

This is where it’s appropriate to describe King and how it operates, as we described before in our own analysis of King. While Privco says there isn’t much of a pipeline, King definitely has a methodology.

King is based in London, and it has its major studios in Stockholm, Sweden. For filing purposes, however, the company has classified itself as an Irish company, based in Dublin. During its rise, King has seen many industry-changing events, such as the shift to social gaming, the rise of mobile, games as a service, the growth of the casual audience, and the free-to-play business model.

The company has been patient and methodical since its founding as Midasplayer in 2002. It first became profitable in 2005 on casual games that often involve puzzles and are easy to learn but hard to master. King published hundreds of casual games on its King.com website and attracted about 10 million users. Once Zynga started making a splash on Facebook in 2008 and got hundreds of millions of users, King turned its focus to social games to join in on the action. Zacconi watched Zynga’s growth closely and wanted to capture some of the magic it had in getting large numbers of users so quickly.

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King’s earlier games were modest when it came to social features. The company was publishing about 15 games a year on its website, but it was slow to shift to Facebook at first. When it launched Bubble Witch Saga and later Candy Crush Saga on the social network, the games shot to the top and gave Zynga some serious competition for the first time. King captured a shift that was happening on Facebook and on mobile as players shifted from simulation games like FarmVille toward faster, arcade-like games with shorter playing cycles. Those games were easier to play while waiting in line at the coffee house, and Zacconi says his company is focused on creating “bite-size brilliance.”

Zacconi’s teams, led by seasoned leaders like Tommy Palm in Stockholm, created and debugged Facebook games one at a time. Then, once they were ready, they launched them on mobile platforms such as iOS. They did it that way because it wasn’t as easy to quickly debug and update games on mobile. Once the teams had the virality and monetization figured out, they launched the titles. So King had a big funnel of a few hundred web games, a smaller number of Facebook games, and a handful of mobile titles.

In contrast to Zynga, which increased its payroll to 3,000 employees, King kept its teams small. Palm led a team of three that worked on a mobile version of Candy Crush Saga, which took advantage of the rapid adoption of smartphones and tablets by the hundreds of millions. The Candy Crush designers created hundreds of levels so players would never run out of something to play. They continuously updated the game. Other titles in the Saga series are similar, with hundreds of levels and plenty of social hooks to keep gamers playing with their friends. King’s games are cross-platform, enabling players to stop on one device and pick up the game on another.

In its filing, King said this process was “repeatable and scalable” and that King has 180 game properties that it owns. It’s not clear how many of those game properties will lead to repeat hits on mobile.

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For investors, that’s the crux of the question. Will it keep on producing the hits? By comparison, King has more mobile revenues than Electronic Arts, which has more than 900 mobile games. EA has hits such as The Simpsons: Tapped Out, but it just hasn’t come up with a game with staying power to occupy the No. 1 or No. 2 position for a year like Candy Crush Saga has.

Another analyst’s view

Arvind Bhatia, an analyst at brokerage firm Sterne Agee, noted that Candy Crush Saga is tracking at about 20 percent below its peak booking levels. So the future growth of the company depends on its ability to diversify. Farm Heroes Saga, which was released on iOS and Android in January, has been gaining momentum, growing from 8 million daily active users to 20 million from December 2013 to February 2014.

At an IPO price range of $21 to $24 a share, King expects to have earnings multiples of around eight to nine times adjusted earnings before income tax, depreciation, and amortization. That’s below the average of 10 times for Activision Blizzard and Electronic Arts. Bhatia predicts year-over-year bookings growth of 32 percent in 2014 and 4 percent in 2015.

As noted by Privco, Bhatia said that revenue concentration in one hit is the No. 1 issue. While King has lots of intellectual properties, three titles accounted for 95 percent of bookings in the fourth quarter. He notes that on Facebook, where King has twice the number of games as on mobile, Candy Crush is only 58 percent of revenues.

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What other game bosses think

Compared to the analysts, industry CEOs are much more excited about the prospects for a King IPO.

“It used to be that you were either a gamer or you weren’t because you had to buy a console. It was a pretty binary thing,” said Walter Driver, the chief executive of mobile-game publisher Scopely, in an interview. “Now everybody has a gaming device. Crossing the line into playing games is very easy to do. That’s how you have [93] million people playing Candy Crush every day.”

Meanwhile, Owen Mahoney, the chief executive-elect of online game-maker Nexon, told GamesBeat, “I’d say that, in general, there’s an interesting valuation difference between public and private. There’s a reasonably high valuation for private companies and a reasonably lower valuation for public ones. We’ll see what happens with the King IPO.”

He added, “My personal view is, that’s what makes a market. From an investor relations perspective, sometimes I don’t like the valuation differences, but from a corporate development perspective, I do. Sometimes it’s the opposite. Right now, I wish there were more reasonably priced private companies. But you always want more of something that you think is good. There are several very good private game companies. Public investors, I think, have been burned, or they feel they’ve been burned by other companies in our industry. They’re pretty skeptical, as a rule. But things like platforms end up going in and out of fashion for investors. Content goes in and out of fashion. It depends on the year.”

Phil Sanderson, a partner at venture capital firm IDG Ventures, said in an interview, “I also believe the King initial public offering is going to be a seminal transaction in the gaming space. It’ll lift that Zynga effect, which has kept a lot of investment down. We started to see a lot of VCs exit the market. When I talked to entrepreneurs, they complained that very few people were making game investments, and that’s still the case. But in venture, it’s often beneficial to be counter-cyclical, to be a contrarian. We know that markets wax and wane. I see a trend happening in gaming that’s starting to wax.”

Sanderson added,”Candy Crush has 93 million daily active users. It’s massive. But if you look at King, they have a platform to make mobile games. Pet Rescue Saga is a real game. There are 20 million daily active users. It’s casual, but it makes a lot of money. Even though King’s revenue declined last quarter, they still did $1.9 billion in revenue in the year. King will be a successful IPO, I think, and it will change people’s views of the market. People will realize that you can make a lot of money in gaming. At that point, valuations will be a lot higher.”

DeWolfe at SGN said, “I’d plan on being self-sufficient as much as possible. There’s not a lot of money going into startup gaming companies. To the degree that you can prepare yourself for fallout in case King stumbles, that’s always a good thing, to be self-sufficient. I was happy that we were self-sufficient when Zynga stumbled because no matter how well we were doing, we couldn’t have raised money during that period of time. Now things are substantially better. The multiples are way better than they would have been a year ago. If King does well, it’s smooth sailing for a long time.”

He added, “If you look at Candy Crush, it’s the past coming back. It’s an old game mechanic, a proven and tried game mechanic, with much better art, much better gameplay, a lot of times a story behind it. Looking to the past and reimagining something that’s been popular in the past, but putting a new spin on it with better art and a new story, is the trend that we’re seeing right now.”