Description

• KING trades for 8.4x 2014 cash from operations less capex.

• Kings return on equity was 71% so far this year (no adjustments with cash balance of $976 million on 9/30/2014).,

However, KING’s flagship game, Candy Crush Saga, represented 69% of the company’s daily active users during February 2014, down from 75% during December 2013. So while Candy Crush Saga grew active users 4% in the eight weeks ending 2/28/2014, KING’s other properties grew faster – perhaps KING is not a one-hit wonder.

Interestingly, KING’s games appeal to a different demographic than traditional computer games (70% of its customers are adult women) and are predominantly played on mobile devices. Also, KING’s games are distributed for free and are not supported by advertising: KING generates revenue by selling virtual items. The business has been cash flow positive since 2005. Perhaps KING has figured out something new; at 8.4x trailing cash flow, investors are being compensated for the uncertainties associated with this new industry.

Thesis

King Digital Entertainment plc (KING) is undervalued. At $16.12, the company is cheap by every metric save tangible book value. The economics of KING’s business require very little capital – as a result, KING’s capital returns are phenomenal, e.g., pre-tax return on invested capital for 2013 was 95%. KING currently has three (3) games ranked in the top 10 of Apple’s top grossing free apps, which suggests that KING is not a one-hit wonder. Unlike traditional game publishers (e.g., Take-Two Interactive, Electronic Arts, Activision Blizzard) KING’s development approach, target market and platforms are different. For instance, developing a new game typically takes a KING team of three people 20 weeks. KING’s target market is women 25-55, and KING’s games may be played seamlessly across PCs, iPad’s, iPhones and Android devices.

Valuation and capital structure

The following table summarizes KING’s current valuation and capital structure.

The table shows that KING has no debt and cash of $976 million (18% of its market capitalization) as of 6/30/2014. Dilution from various compensation plans totals 12.3% - this is approaching our tolerance threshold.

Business and Background

Current management founded KING in 2003; the company creates and publishes casual games played on computers and mobile devices including iPhones, iPads and Android-based devices. Its games are synchronized across platforms, e.g., a player could start a game on a PC via Facebook, then later log into the game using an iPhone during a commute to work (picking-up where she left off) then return to the game on an office computer during lunch break. During Q4 2013, 73 percent of KING’s gross bookings were from players using their games on mobile devices. This suggests the KING business success is a derivative of the rapid growth of smart phones and tablet computers. KING hosts its games on its own servers running proprietary software on commodity hardware (each server supports 700,000 daily active users).

The company’s games are free to download and play; KING makes money by charging players for virtual items, e.g., if a player runs out of “lives,” she can wait a few hours and be given another life at no cost or convince a friend to give-up one of her lives or pay 99¢ and purchase more lives. Stating the obvious, it is economically attractive to sell virtual items: zero cost of goods sold! During February 2014, the average number of daily active users of KING games was 144 million, up from 128 million during December 2013. About 4% of KING’s average monthly unique users purchase virtual items; KING had 304 million unique monthly users during December 2013. One can see how selling virtual items to a small fraction of 304 million monthly users generates significant cash flow.

Casual games differ from console-based games (sometimes referred to as hardcore games) in a number of ways. First, casual games may be played in short, discrete amounts of time and tend to be simple to learn. Early examples of casual games include Pac-Man, introduced in 1980 by Namco and considered by many to be the original casual game, and Tetris, published by Alexy Pajitnov in 1984. Casual games do not depend on processor intensive graphics, and they can be effectively played on a wide range of devices (PCs, smart phones, tablet computers). Most importantly, many causal games, at least as of this writing, appeal to a different demographic from traditional digital games: 70 percent of KING’s customers are women age 25 to 55. Traditional digital games also have a well-established sales cycle which tracks the introduction of new game consoles and features strong sales in Q4 due to holiday gift buying. Casual games are new enough that it is difficult to know what relationship they have to new device introductions. KING’s experience does show that daily active users (DAU) grows after the introduction of a game to mobile platforms, e.g., their Farm Heroes Saga increased daily active users 150% in eight weeks after being released for mobile devices in January 2014. Unlike traditional console games which demonstrate peak sales in Q4, KING generates more revenue in the summer. Flurry Analytics, a consultancy, estimates that game play represents 39% of time spent using smartphones and 67% of time spent using tablet computers. The point is that while KING is in the game business, its business is quite different from that of traditional console game suppliers, e.g., Nintendo, Sony, Electronic Arts, Take Two Interactive and Activision Blizzard.

Management and IPO

Melvyn Morris (57), Riccardo Zacconi (46), Toby Rowland and four others founded KING as Midasplayer.com Limited in September 2002; at the time, Morris, Zacconi and Rowland worked together at uDate. Morris is KING’s chairman and Zacconi its CEO; Rowland left Midasplayer in 2008.

Prior to cofounding Midasplayer, Morris founded uDate.com in 1998. Morris sold uDate to USA Interactive on 4/4/2003 for $150 million. Zacconi started his career working for L.E.K. Consulting then moved to The Boston Consulting Group. In the late 1990s, Zacconi joined Internet startup Spray Networks as a managing director – Spray was a Swedish based Internet portal. Spray was sold to Lycos in September 2000. Zacconi then spent a short time at Benchmark Capital as entrepreneur in residence before joining Morris and Rowland at uDate in 2002. Zacconi was Vice President of European Sales and Marketing at uDate.

Initially, Midasplayer distributed its games in the U.K, Sweden and Germany via its own website, Midasplayer.com. The company generated revenue by charging a small fee to players. Apax Partners, a UK based buyout firm, and Index Ventures, a Geneva based venture capital firm, invested €34 million into Midasplayer.com in August 2005. Midasplayer.com was rebranded King.com during Q3 2005; the company has generated positive cash flow every year since 2005. Shortly after receiving the Apax investment, KING partnered with Microsoft, Yahoo! and AOL to provide games on their portals. At the time, portals were paying to have games on their web sties in order to attract users and would share advertising revenue with KING. This arrangement persisted until portal gaming traffic started to dry-up in 2009; according to one account, Yahoo!’s gaming traffic was down 45% for the 12 ME 3/31/2010. KING management noticed that gamers playing resource-management games on Facebook (e.g., Zinga’s Farmville) were the same demographic that KING served: women over 25. KING modified its games and partnered with Facebook; the following table summarizes the result:

KING Metrics since 2011

KING paid a $287 million dividend to its shareholders on 10/24/2013 and paid a second dividend of $217 million on 2/6/2014. It conducted its initial public offering on 3/26/2014, selling shares to the public for $22.50. The following table summarizes the origin of shares sold during the IPO.

KING IPO, 3/16/2014

Note that selling shareholders sold only 2% of their position – of course, they more than recouped their initial investment as a result of October and February’s dividends. The following table summarizes KING’s ownership immediately prior to the IPO and immediately after the IPO.

KING Ownership Structure

As is often the case, while management sold only 3.2 million shares during the IPO, in the months preceding the IPO they were granted options for 24.5 million with a weighted average strike price of $12.89, i.e., below the IPO price of $22.50.

Game Development and Virtual Items

Traditional console-based game development cycles are long and expensive. For example, Electronic Arts announced the development of Star Wars: The Old Republic on 10/21/2008. The game was released on 12/20/2011 and development costs were estimated to be in excess of $150 million. KING’s games, in contrast, are developed quickly and tested on KING’s website before broader release. Developing a new game typically takes a KING team of three people 20 weeks. In the words of Zacconi, “If a game doesn’t work, it fails fast and cheap.” There is nothing proprietary about KING’s methods and KING is not the only company making casual games in this way (though KING, like every other game development company, touts its process to repeatedly develop hits). Our point is that the casual game business, as practiced by KING, is different from traditional console games in terms of audience (women), game development (quick and cheap) and monetization (free-to-play, revenue generated by the sale of virtual items).

Most players of KING’s games reach the highest level of the games without making a purchase. For those who make purchases, KING offers four categories of virtual items:

• Entertainment time. Players may purchase additional moves or additional lives.

• Skill enhancement. Players may purchase skills which help them play the game.

• Content access. Players may purchase access to a new episode in lieu of performing a number of quests to earn access to the episode.

• Collectible items. Items that enhance a player’s status among other players.

The following table summarizes KING’s revenue by region.

Revenue by Geographic Region of the Player

On 4/26/2014, KING signed an agreement with Tencent, a Chinese media company that owns WeChat (200 million users in China) to distribute KING’s games in China.

Why KING is cheap

KING’s daily active users increased 13% in the eight weeks ending 2/28/2014. This is remarkable in and of itself, but even more remarkable is the observation that an increase in daily active users correlates with an increase in revenue – revenue generated by selling virtual items that have zero cost of goods sold.

A number of commentators dismiss KING as a symptom of a market bubble – if they are referring to the company’s valuation, they haven’t read KING’s 2013 financial statements. Another common complaint about KING is that it is another Zynga, Inc. (ZNGA) – the previous Facebook gaming champion. No one is anxious to own another ZNGA. While both companies make casual games and use Facebook as a distributor, KING differs from ZNGA in a number of respects. First, KING has one share class while ZNGA has three share classes, two of which have super voting rights – from our standpoint, other things equal, this would disqualify ZNGA from further consideration. Setting this aside, compare ZNGA’s valuation with that of KING. The following table summarizes KING’s valuation metrics based on earnings since 2009.

KING Valuation Metrics at $17.81 / share

KING is expensive on a book value basis, but being asked to pay 10.5x earnings (which are likely growing) seems like a reasonable price in exchange for bearing the uncertainty of what may befall KING in the future. Now lets take a look at ZNGA’s valuation metrics (ZNGA came public on 12/15/2011).

ZNGA Valuation Metrics @ $4.08 / share

ZNGA’s valuation looks crazy based on $4.08 / share; it was even crazier at its IPO price of $10.00. The following table compares the cash flow of KING and ZNGA over recent years.

KING’s cash generation during 2013 was phenomenal – nearly twice what ZNGA has made since 2009 (and two orders of magnitude greater than what it had produced in prior years). The following table compares operating metrics between KING and ZNGA.

Average Year End Operating Metrics: KING vs. ZNGA

In addition to the astonishing growth of KING’s operating metrics during 2013, KING’s operating metric growth exceeds anything ZNGA experienced. We don’t have the benefit of metrics for 2009 – 2011, but through 2010, KING distributed its games via portals, e.g., Yahoo!, so it was a different business in terms of distribution channels. In summary, KING is superior to ZNGA on a capital structure basis (no super voting shares), is cheaper than ZNGA by every metric except book value and is superior to ZNGA by operating metrics and operating metric growth. Also, ZNGA has yet to earn a reasonable return on capital while KING’s capital returns are phenomenal. ZNGA’s games also lack the ability to seamlessly port across different platforms – a feature that KING’s customers seem to like. These observations do not guarantee that KING will not follow ZNGA’s footsteps in terms of how its business develops, but they do suggest that KING is a better business at a better valuation.

The freemium-based casual game market targeting middle-aged women is new. One could make the case that it is a hit driven business and KING has its one hit, Candy Crush Saga. While this may turnout to be the case, what would one call KING’s Farm Heroes Saga, which increased average daily active users from 8 million in December 2013 to 20 million in February 2014, when it accounted for 14% of KING’s traffic? Note that ZNGA’s average daily active users at the end of 2013 was 37 million i.e., based on the growth during the first eight weeks of 2014, the number of Farm Heroes players may approach the number of all of ZNGA’s games as of this writing. It looks like Farm Heroes may be KING’s second hit, but how long does a hit last? Angry Birds, published by privately held Rovio Entertainment and first released on Apple iOS in December 2009 remains popular, though it is past its prime. KING has this to say about its experience so far:

We have a track record of successfully attracting our audience to new games and retaining them within our network: the average Bubble Saga [a game which preceded Bubble Witch Saga] player who joined our network in May 2011 subsequently installed five additional games. Our most mature franchise has continued to experience relatively high gross bookings as a percentage of its historical peak gross bookings. The median gross bookings over the 21 months from reaching this peak, as well as the month of December 2013, were 71% of this peak.

Some speculate that there are low barriers to entry to the casual game business. This may or may not be the case. Like the music business, it may be that while just about anyone can create a game (or write a song), creating a game that attracts 90 million daily users is an all together different matter (not everyone can write Eleanor Rigby). There is also the concern that KING’s margins will be whittled away by its distributors (Facebook, Apple, Google). Obviously there will be a push and pull between KING and its distribution partners – but it is not clear that the marketing partners hold all the cards, i.e., both parties appear to have leverage.

In summary, KING is producing net cash at an accelerating rate, currently $160 to $200 million per quarter. While it is hard to say what the life cycle of their games will be, they currently have three games in Apple’s top ten grossing free Apps. We think there is enough upside optionality built into the modest valuation to compensate for the uncertainties associated with this investment. Thought of another way, how cheap would KING have to get to be attractively valued based on what is knowable today? $16.12 looks like a bargain.

Catalyst

1. Customers continue to play Candy Crush Saga.

2. Continued growth of of their other games.