Stay away from King, The Emperor has No Clothes

TAGs: Candy Crush Saga, Editorial, IPO, king, king digital entertainment, Rafi Farber

Investing can sometimes resemble actual gambling, but ideally it really shouldn’t. It should be a game of skill rather than a game of chance. But if you haven’t been to Vegas in a while and you miss that gambling high – that dopamine-surge you get in your brain from true random chance, then by all means, take a position in King Digital Entertainment (KING).

King Digital EntertainmentFirst, let’s go over the problem with social gaming stocks in general, then I’ll get into KING specifically. It has to do with the nature of what capitalism is. The modern gaming industry simply does not warrant the issuance of massive IPO’s with multibillion dollar valuations. The purpose of IPO’s, of any equity issuance really, is to enable a company to invest in capital in order to expand its business. In other words, the point of being traded on the capital markets is to raise capital which in turn is used to produce consumer goods. This makes sense for capital intensive operations like mining, agriculture, real estate, restaurants, hardware manufacturing, cars. It also applies to some software companies whose software contributes some form of measurable service value like Google, Microsoft or Yahoo. Capital requirements for these companies are mostly labor and some hardware, so equity makes sense.

But when you get to social gaming companies, there really are very little capital requirements for a successful game, and developing one is more of an accident than an entrepreneurial plan. Look at Flappy Bird for example. Created by a single Vietnamese developer who had absolutely no idea it would go viral, graphics ripped right of Nintendo, exceedingly simple design. How long did it take to program and how much capital did it require to develop Flappy Bird? A few hundred bucks maybe?

Now imagine that Dong Nguyen suddenly applied for an IPO. What would be the purpose of that? To expand Nguyen’s business and enable him to program even more exceedingly simplistic tapping games he can probably code and upload in a week from his mom’s basement? Why would he need billions of dollars to do that? All he needs is a few TV dinners and a computer to churn something like that out. The rest of the IPO would simply go into his pocket, a donation from stockholders. What’s he going to do with all that money? Expand his “company”?

Shareholders of Flappy Bird would then be relying on Dong to hit the jackpot twice, three times, four times, for his games to be worth billions in order to justify the crazy valuation of his company. What happens, though, if some 16 year old in Malaysia somewhere comes out with another strange accident of a game he uploads to the Apple App store, and it’s just as addictive as Flappy Bird for whatever reason? What happens is people will forget about Flappy Bird and move over to this new game, while Flappy Bird shareholders will hold the proverbial bag.

Gaming companies weren’t in the same situation in the 90’s and early 2000’s. Back then, gaming took capital, consoles, cartridges, manufacturing centers, distribution channels, marketing. Now it’s much simpler, the barriers to entry almost nonexistent, success ever more fleeting and random.

The numbers in the whole social gaming industry tell the whole story. They make no sense. Electronic Arts (EA) lost over half a billion dollars in the last 6 months and its stock is at 5-year highs. Or Activision Blizzard (ATVI), a company that unlike EA has actually earned money ($2.7B) over the course of its existence, but has far less capital gains over all than EA, a company operating at net loss.

Does any of this make any sense? It makes about as much sense as gaming fads themselves.

As for Zynga (ZNGA), it has one megahit, Farmville, and decides to throw out a multibillion dollar IPO. For what? So it can acquire another gaming company OMGPOP for $200M, and then…

[I]n the third quarter of 2012, we made the decision to discontinue the development of certain games associated with technology and other intangible assets previously acquired from OMGPOP and we recorded an asset impairment charge of $95.5 million. (ZNGA 10-K, page 17)

Why did Zynga cut resources away from its OMGPOP division? Because people’s tastes change. Zynga now has a cumulative loss of close to $1B, and don’t expect that number to reverse any time soon.

How do games differ from other software apps that have measurable value? The value of a game is accidental and relies entirely on whether people happen to like playing it or not. When they get tired they’ll find another game. Other apps like Waze or Whatsapp, notwithstanding the enormous sticker price on the latter, have actual value in the utility they provide to consumers. This makes them not simple luck fads, but actual things people need on a consistent basis.

How do social games differ from iGaming then? Because iGaming and online gambling relies heavily on trust through branding and brand recognition. You don’t just put your bankroll up on a site you discovered yesterday developed by an anonymous Vietnamese programmer. This is a significant barrier to entry. But you would pick up a game like that just for fun.

And of course, this logic does not apply to brick and mortar casinos, which are extremely capital intensive and not at all fads based on luck.

It does apply though, and in spades, to King Digital Entertainment. This is nothing but a slightly more sophisticated Dong Nguyen Flappy Bird IPO. 78% of its whopping annual revenue of $1.9M comes from Candy Crush. (Not bad for a $6.6B IPO!) The company has made moves to trademark the word “Candy”. It trades under the very humble symbol KING. Is it possible that its Candy Crush success has gone to its head, or that the underwriters of this IPO have milked it for every dollar and are now throwing a big party for themselves on a yacht with your capital?

When the next Dong Nguyen peeps out of his mom’s basement with the next gaming fad, people will see that the KING is in fact just a commoner, and the Emperor has no clothes. When options trading opens up on KING, a few puts and you could buy a very nice wardrobe yourself.


views and opinions expressed are those of the author and do not necessarily reflect those of