King Digital Is One Of The Market's Cheapest Stocks, But Is It A Buy?

While the official Magic Formula screens and our own screener don't always agree, they do agree on the stock I want to highlight today, King Digital (KING).

There can be no dispute that KING is one extraordinarily cheap stock. It is also difficult to dispute that, at least over the past 3-4 years, KING has been a remarkably well-run company.

That said, there are some risks that give pause and help explain the stock's low valuation. Let's take a look at this interesting opportunity.

A Sweet Business

As I'm sure many readers already know, King Digital is one of the largest new-age game companies focusing solely on casual games for mobile phones (Apple's iOS and Google's Android) and, to a lesser extent, Facebook and the web. King's games are designed as free-to-play, with monetization coming in the form of in-game currency and items, add-on content, and some in-game advertising.

King has four ongoing game franchises:

Candy Crush

Candy Crush Saga: this franchise of "match 3" puzzle games consists of the enormously popular Candy Crush Saga and its follow-up Candy Crush Soda Saga. In the most recent quarter, these games accounted for 39% of King's gross bookings (about $206 million), which was down from 59% ($360 million) a year ago. The series also has a very impressive 98 million daily average users (DAUs) as of the most recent quarter.

Farm Heroes Saga: Another "match 3" puzzle game, this time matching different crops to meet the goals of the different puzzles. Farm Heroes has roughly 20 million DAUs.

Pet Rescue Saga: Another puzzler, where players match boxes of similar colors to remove board pieces and "free" animals once they reach the bottom. 8 million DAUs.

Bubble Witch 2 Saga: Aiming colored bubbles at the board, matching 3 bubbles to clear the board. Also about 8 million DAUs.

For over 2 years now, King has had 3 games in the top 10 of Apple's App Store and Google Play, a pretty impressive feat. The company has shown the ability to follow up its breakthrough hit Candy Crush with solid follow-ups and extensions.

A big reason for this is King's absolutely enormous 500 million-plus average monthly users. This is a fantastic marketing asset, allowing the company to introduce new games and in-game offerings to a highly interested audience at virtually no cost.

King is also a lot better organized than many of their competitors. The company has developed a common internal platform that allows synchronized games across devices and platforms, as well as centralizing player databases, user analytics, and marketing across all games. Consider that King's revenue base is 3 times that of Zynga (ZNGA), with huge profitability (34% operating margins), on just a fraction of the games (13 vs. over 30), and the operating prowess of this firm is clear.

Oh, and King is debt-free. With almost $800 million in the bank. And free cash flow exceeding $620 million annually.

A "sweet" business, indeed!

Why So Cheap?

It is clear why King is so cheap. The market believes the company is another one hit wonder and that its current cash flow generation and profitability can't and won't last.

Let's be blunt - there is good reason for the skepticism. The fervor around Candy Crush is certainly wearing off, and King is seeing year-over-year revenue drops in the mid-teen percentages this year. It has not been able to fully follow up on its breakout hit, although it has been able to mitigate much of its decline, considering the Candy Crush games alone were down almost 45% in bookings year-over-year last quarter.

Most aptly in my opinion, there is just enormous competition in the iOS/Android gaming space. The big gaming companies, like Activision (ATVI) and Electronic Arts (EA), compete here. Disney (DIS) produces dozens of game apps. Mobile-only gaming companies such as Gameloft, Rovio, Glu Mobile, and Tencent, are direct competitors vying for gamer's limited time and money.


The market also makes the unavoidable comparison to Zynga, who's initial hit Farmville the company could never follow up on, and which now trades in the $2 range.

What is King Worth?

This is really the $4 billion dollar question. Although King looks quite cheap, with an earnings yield over 20% and a free cash flow yield nearing 18%, will players burn out on its puzzle games and leave the company in the dust like Zynga?

Well, first, I think Zynga is not a great comparison. Zynga was never as well-run as King is - not even close. Even in the heady days of Farmville, Zynga was unprofitable and a meager cash flow producer. So while it is appropriate to model in a business decline as Candy Crush flames out, I don't see it as an existential risk to King.

King is planning to continue to extend its major franchises with a new game every year, with 8-12 releases annually. It will continue developing content and level additions for existing games. Early next year, it is planning its first "mid-core" game, focused on more advanced gamers. With the company's experience and huge marketing base, I feel it can at least mitigate the bulk of Candy Crush declines over the next few years.

There is also the firm's cash balance and cash flow to consider. King just recently began buying back shares, and could easily accelerate this to reduce share count by 10% or pay a large special dividend if it so chooses. Alternatively, it could look to consolidate the mobile gaming space even further, perhaps by pursuing somebody like Rovio or Game of War maker Machine Zone.

In all, modeling in reasonable cash flow declines to the tune of about 5-6% per year over the next 5 years (after a 15% drop this year), followed by modest growth longer-term, I think King could be worth about $17. I also believe there is reasonably high uncertainty and that the firm could be worth much more than that... or much less. It is a tough company to forecast, with high uncertainty. MagicDiligence would like to see the company come down near $12 before getting considering it as a Top Buy option.


Disclosure: Steve owns no stocks referenced here.

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Oren Adler, CPA 8 years ago Member's comment

I got burned with Zynga. There are too few Ataris in the world, gaming companies that can make the long haul. I doubt I will ever invest in an app game again. I fear these games are fads with a shelf life counted in nano-seconds.