Description

I am short KING because it’s stupid. The company is best known for publishing the casual game Candy Crush, from which they derive about 50% of their revenue from. Forget the borrow costs, the low trailing p/e, and the weak IPO - KING is a short.

Casual games is usually a terrible business, with one big caveat. By nature, the customers have a low engagement and loyalty to the game...they are casual, they just don’t care that much. Nevertheless, every now and then a developer manages to catch lightning in a bottle, which is exactly what’s happened with Candy Crush. Unfortunately, these games usually have relatively short shelf lives. Angry Birds. Farmville. Mafia Wars. Deer Hunter. Temple Run. Megapolis. Tiny Wings. Fruit Ninja. Draw Something. Words With Friends. And now, Candy Crush. I’m certainly not the first person to brand KING as little more than a one-hit wonder without much if any franchise value, but that doesn’t mean it’s not the truth. Candy Crush is a time-waster for bored housewives who will inevitably move on to another game.

Here’s the key to understanding KING: their recent historical results of KING are in no way reflective of an actual game developer or what the company will look like going forward. Here is the story that the company (and bulls) are trying to sell you:

Today, KING looks completely different than its financial statements, which are those of a single asset that is more-or-less a fluke. They don’t have any other viral hits and no one has any idea what makes something go viral. Instead, KING now has an army of developers making mostly similar (and imho, lame) games, while even more money is spent on marketing the new titles. They will do their best to leverage the “platform” where they cross-market other games from existing Candy Crush user base, and they have now committed to releasing more games every year in the hopes of finding the next Candy Crush. But throwing crap against a wall and seeing what sticks is expensive, and KING’s cost structure is unrecognizable compared to just a year ago. Furthermore, the success of Candy Crush and other viral titles shows that there is little value in the platform. If the platform is so valuable, why are so many of the best-selling games these one-off viral hits in the first place? Better yet, ask ZNGA how valuable the platform is. In many ways, the platform is crippling to the company since “platform” is just a term for “we’re obligated to spend a gazillion dollars on development and marketing”. Management actually boasts about having developed “over 180” titles as if this fact is encouraging. This statistic is utterly dreadful and speaks to the arbitrary nature by which games become massive hits. KING has taken over 180 shots over ten years and they’ve scored just one goal.

Farmville is a good template for how this works, and for better or worse, it’s about the only other major title where you can get broken-out financials. Revenues peaked at $85m/quarter in 2012, and in the third quarter they were almost nonexistent at $8m. Thus concludes today’s lesson in casual game economics.

Candy Crush is in the early stages of this decline, and bookings declines are accelerating. Assuming KING somewhat arrests the declines in Candy Crush, I still estimate that Candy Crush bookings will be down 50% yoy in Q4.

Candy Crush isn’t KING’s only problem though, as non-Candy Crush titles (which are typically the same genre as Candy Crush) are stalling out. In Q3, gross bookings increased just $14m vs Q2, their worst qoq increase to date. This is even more worrisome considering that as recently as Q1, bookings had grown by $72m. KING keeps releasing new games, but the reality is that at their size, it’s really hard to grow without a viral hit.

The real question is whether these other titles actually generate any profit for KING. I suspect they don’t. In the third quarter, KING generated $170m in pre-tax profit on revenue of $515m. But if you think about KING, this is really two vastly different companies rolled into one. On one hand there’s this gigantic money printing machine that has very little marginal costs. On the other there’s a proper game company that’s developing about a dozen new titles per year, marketing them, running analytics, etc. You know, an actual company rather than this freak asset that’s in decline.

Of the $515m in revenue, Candy Crush generated $280m and it’s fair to say that its contribution margin is extremely high. KING had $180m in opex between G&A, R&D, and S&M. (cogs was $165m but it’s a simple distribution expense paid to iTunes et al and is ~30% of revenue, so I exclude this from opex) Candy Crush was released in 2012, and during those early days when the company was almost entirely Candy Crush, KING’s quarterly opex (less cogs) was $25-40m. If you assume that Candy Crush today has marginal opex of $35m per quarter (which is probably generous), that means Candy Crush was directly responsible for $160m of KING’s $170m in pre-tax profit in Q3. The point is that the non-Candy Crush business is a sideshow to the massive Candy Crush declines. The rest of the business, which is what they will eventually be left with, basically breaks even and is showing troubling signs of stagnation.

The third quarter beat expectations and the stock is up 40% on a combination of a not-disastrous quarter and “excitement” over the launch of the most recent Candy Crush spinoff title, Candy Crush Soda. I have two takeaways from KING’s recent results and why the stock is now set up well as a short.

First, this company is extremely clever when it comes to monetization. I really have to hand it to them, they know all the tricks to extract money from players. For example, they have a virtual currency of gold bars to make you forget it costs real money. They’re also really good at teasing users with easy levels and getting them to feel emotionally invested into the game. Then they slam them with hard levels that require payment to proceed. They especially do this for players who have been inactive for a longer period of time. All of these tactics are evidenced in their MGABPPU figure, which is basically a calculation of how much money paying players are forking over on average. It had been mostly flat even while Candy Crush’s popularity exploded, but it significantly (and unexpectedly) jumped 26% yoy in each of the last two quarters. I give them credit for effectively dangling those carrots and improving monetization.

Second, the company likes to talk about daily active users (DAU’s) as the main engagement metric, but I believe DAU’s is the wrong way to look at this business. DAU’s is like a retailer counting window shoppers as customers. It’s worthless, literally. What matters for KING is paying customers (MUP’s). On that front, the business is in serious trouble, with monthly paying players down 33% yoy and 17% qoq during the third quarter. It peaked at 13m a year ago and today stands at 8.7m. Like with Candy Crush bookings, the MUP declines are accelerating as only the hardcore customers are sticking around.

KING is obviously doing a great job at milking hardcore customers (I’m guessing these are the same people who buy lottery tickets and read InTouch Magazine), but I believe this has only temporarily made things look stable. The two problems with monetization are that (a) it has an upper bound and (b) it comes with the tradeoff of angering customers. It can’t go on like this much longer, and I don’t think it’s an accident that KING started employing these short-sighted tactics only after becoming a public company, thereby subjecting themselves to the myopic pressures of quarterly results. Monkeying around with monetization might work in the short-run, but when customers no longer find it worth spending any money on your games, or are just plain pissed off at you because they think you manipulated them into giving you more money, monetization tactics are irrelevant.

KING’s stock is up 40% in the last several weeks. The quarter was perceived as “good”, although the beat was largely driven by the not-well-understood seasonality in the business, since they saw a noticeable improvement in bookings after school started and all the bored housewives went back to their depressing lives. Really though, the stock is up on Candy Crush’s extension title, Candy Crush Soda, which was released last week and immediately shot to #1 on the app charts, likely because of nothing more than Candy Crush’s brand equity. The game is lame, it’s not materially different than Candy Crush at all, and the reviews of it have been tepid. For example:

“The original Candy Crush Saga is a fun game and so is Candy Crush Soda Saga. But while there is no denying that, there is also no denying that the game’s business model is absolutely horrible and is essentially designed to annoy you and your friends into either paying or stop playing altogether. It’s everything that is wrong with the mobile gaming industry, which is why it’s hard, in good conscience, to support and recommend these games.”

Yes, you could accuse me of cherry-picking that one, but oh well, google around and see for yourself. Crappy user experiences are not sustainable.

Anyway, KING is worth a fraction of today’s price. Candy Crush will fade and the revenue decline combined with new cost structure will push eps to $.70 in 2015, $.30 in 2016, and losing money 2017. All of this assumes they manage expenses along the way. The street is delusional about the earnings trajectory and numbers are going to need to come down a lot. The stock is worth maybe $5/share. Along the way we might get lucky and they could do some horrific deal like another OMGPOP!. On the other hand, they are good at returning the ephemeral cash flow to shareholders.

Catalyst

Candy Crush