Why I expect the valuation of King to fall by half

This post originally appeared on GAMESbrief.

The valuation of King has me terrified.

If King tanks after its stock market debut this week (and I think it will), that will be bad news for the games industry for the next three years.

Zynga’s miserable performance is still fresh in people’s minds. Zynga convinced the market that its metrics-driven design process had eliminated the risky nature of the games industry. It had two proven “franchises” in the “Wars” games (although these had peaked) and the “-Ville” games and acquired a third (“With Friends”) through acquisition.

Yet all the metrics in the world couldn’t hide the fact that the titles were formulaic and derivative. Zynga has indeed brought metrics into the mainstream of the games industry, much to the good, but it has also demonstrated the limits of metrics. Metrics-led design can only seek out local maxima. It can make what already exists better. What it can’t do is take designers and players on new journeys, to new experiences that inspire their souls. Metrics-led design is good; creative-led, metrics-informed design is way better.

Which brings me back to King, which is expected to price an IPO this week with a valuation of $7.5 billion. My rough estimate is that King’s valuation should be is nearer to half that.

King’s success is predicated on one game, Candy Crush Saga, and one franchise, the “Saga” series, which it humorously calls its “first” franchise. Candy Crush Saga makes up 78% of gross bookings for the company. Three games – Candy Crush Saga, Pet Rescue Saga and Farm Heroes Saga – make up 95% of gross bookings. The company has also grown sharply. Revenues rose from $64 million in 2011 to $164 million to an astonishing $1.9 billion in 2013, mainly on the back of Candy Crush Saga.

What can grow ten fold in a year can fall ten fold in a year

I am in awe of what King has achieved in the past 11 years. Founded in 2003 as a skill gaming business, King has pivoted three times, first away from skill gaming, then from the browser to Facebook, then from Facebook to mobile. Any company that can achieve a successful pivot once deserves our respect. A business that can do it three times is impressive indeed.

It has also got lucky. Candy Crush Saga is a phenomenon up there with 50 Shades of Grey, Flappy Birds and Gangnam Style. A global phenomenon that captured the zeitgeist. Psy, the creator of Gangnam Style, was sanguine about his success. “It wasn’t me. It was the people. And what happens if they don’t do it again next time.” And they didn’t. Can you name Psy’s next YouTube hit after Gangnam Style? *

King’s valuation is predicated on the continued success both of Candy Crush Saga and of a successor to Candy Crush Saga. It’s $7.5 billion expected valuation is barely 10x the operating profit the company made in 2013. Which is a steal if you believe the 2013 operating profit is a good proxy for performance in the future.

Which I don’t.

What does King look like as a steady state company

I believe that King is a three product company that has a good track record of putting out high-quality casual games on multiple platforms. It has also struck oil once. I am nervous valuing it on the basis of striking gold again.

I have tried to “normalise” King’s business. Out of its $1.9 billion in 2013 revenues, Candy Crush Saga represented 78% or $1.47 billion. It makes 95% of gross bookings when added to Pet Rescue Saga and Farm Heroes Saga. Stripping Candy Crush Saga out suggests that Pet Rescue Saga and Farm Heroes Saga made $320 million in 2013, or $160 million each. So a steady-state King game, by my estimations, makes around $160 million a year.

There are some heroic assumptions in here. The 78% and 95% figures are based on gross bookings, and I am assuming they apply equally to revenue. I am treating Pet Rescue Saga and Farm Heroes Saga equally, even though Pet Rescue Saga has 15 million DAUs and Farm Heroes Saga has 8 million DAUs. I am crediting King with being able to create these franchises without the halo effect and cross promotional benefits of the Candy Crush leviathan. But bear with me.

So looking forward, let’s assume that King has three “steady state games” (CCS, PRS, FHS) and can produce another in 2014. That would suggest revenues of $640 million. (4 x steady state game revenues of $160 million). Strip out 30% platform holders fee leaves $450 million in net revenue (or gross profit depending on your definitions). Margins are likely to be under pressure, as King invests heavily both in new development but mostly in defending its position with marketing spend, so I estimate a 30% operating margin on the net revenue, leaving operating profit of $135 million.

Put that on a multiple of 15x and you get a valuation of just over $2 billion. Put it on a multiple of 20x and the valuation is $2.7 billion.

But what about Candy Crush?

Of course that valuation ignores Candy Crush. And you can’t ignore Candy Crush Saga, because without it King wouldn’t be floating. But how to value a one-off hit that King has not been able to replicate and that appears to have peaked? King’s Q4 2013 revenue numbers fell in the fourth quarter of 2013, the last quarter for which numbers are available, from $621 million to $602 million. Candy Crush Saga may have peaked in July, according to analyst Arvind Bhatai at Stern Agee.

But peaking doesn’t mean the same as “is over”. It’s a still a single game making around $1.5 billion a year. It has 93 million Daily Active Users (although King does count the same user playing on tablet, smartphone and Facebook as three Active Users). It is a profitable, declining business. If you knock off the platform fee of 30% and assume a 30% margin on net revenue, it is still making $315 million of profit a year.

So a declining business making $1.5 billion in revenue and $315 million in profit. Perhaps its worth 1x sales ($1.5 billion). Or 10x profits ($3.1 billion). Let’s split the difference and call it $2.3 billion. But we’ve already included $500 million of value for Candy Crush Saga in the steady state valuation above, so the Candy Crush Saga “premium” is $1.8 billion.

What about the next hit?

All of this is valuing King on its fundamentals. But what about the potential for it to make the next big hit?

At one level, what about it? That is not a game you should play in the stock market. That is for investors with high risk tolerance, probably in the public markets. But let’s be generous. Let’s assume that there is some valuation sizzle for the potential for King to knock another one of the park. I’ll add an extra $575 million for this, which is a quarter of the Candy Crush Saga valuation and implies a one in four chance of it happening. I think I’m being generous.

So what is the valuation

This process gives me three components to King’s valuation:

Combined, that is a valuation of $4,875 million.

I could be accused of making aggressive assumptions both for the bull case and the bear. I have assumed King maintains a 30% margin after the platform share, which is much lower than its current margin, which is enhanced by the success of Candy Crush and much higher than its historic margins – the company was loss making in 2011, for example. Marketing costs are going up as the market becomes more competitive. I have based my valuation on historic figures when any analyst worth his salt knows that it is only forecasts that matter. Arvind Bhatia estimates that King’s 2014 revenues will be $2.62 billion. I haven’t seen a detailed forecast, but if margins stay steady at 38% of gross revenue, that’s $1 billion in operating profit. On that basis, a $7.5 billion deal sounds cheap.

Which is the whole conundrum of King’s valuation. The company has struck oil. It is not pricing at the top end of the comparables on the basis of this dependence on a single title. It probably seems to executives and shareholders at the company as if this valuation is a steal.

I have enormous admiration for King. Its three pivots, its doggedness, its ability to not only bottle lightning but then to harness it to launch other titles have all been enormously impressive. To the risk takers and entrepreneurs who founded and invested in the business, it’s looking great. But to the investors in the public markets, the pension funds and life insurance companies and widows and orphans, their tolerance for risk is much lower.

So my conclusion is that King’s real valuation is below $5 billion, not over $7.5 billion. I expect that the banks will get the IPO away, because I have rarely seen an IPO get to this stage and not happen. But I expect the buyers to be the ill-informed and the followers, not the price setters. I expect the price to fall over the next four weeks. If it does, it won’t fall to my $5 billion. The market will get angry and fearful. The price will plummet.

I hope it doesn’t. I really do. Because of my respect for what King has achieved and because of my fear for what a second failed IPO would do to the market.

But it was I think will happen. Which makes me sad.

Nicholas Lovell is the founder of GAMESbrief, author of The Curve (Portfolio Penguin) and The F2P Toolbox, a former investment banker and a F2P design consultant.

* It’s called Gentlemen.

The numbers in this piece are predominantly drawn from King’s registration statement .