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Candy Crush-Maker King Digital IPO Riskier than First Glance

NEW YORK (TheStreet) -- By internet company standards, King Digital Entertainment, maker of the popular mobile game Candy Crush Saga, is wildly profitable. However, the mobile gaming app maker may be riskier than its profit and loss statements indicate.

King Digital said on Monday it plans to sell 22 million shares in its initial public offering at an initial price range of $21 to $24 a share. At the high end of King Digital's range, the company would sell $532.8 million in shares, for a full valuation of about $7.6 billion. Prior to the Facebook (FB - Get Report) and Twitter (TWTR - Get Report) IPO's, King Digital's listing would rank as one of the biggest internet stock offerings since the financial crisis and on a short list of IPOs raising over $500 million.

In some respects, King Digital's ambitious IPO range and valuation are no surprise. The company, after all, is solidly profitable, having generated $4.38 in diluted earnings per share (EPS) in 2013. As such, the company is seeking to go public at a valuation of only 5.5 times its trailing 12-month EPS, a comparatively low valuation when contrasted with other recent internet IPO's, including Facebook, Twitter, Groupon (GRPN) and Zynga (ZNGA).

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But King Digital's exceptional profitability may actually present a big risk for prospective investors.

King Digital will have to prove that it isn't a fad, an issue that has plagued Zynga since its IPO and a moderation of user engagement with its linchpin FarmVille game. Investors in King Digital, by way of its addictive Candy Crush Saga game, faces a similar risk.

King Digital's current business model goes as follows: The company offers its popular games for free, meaning that its user base of over a quarter billion  isn't necessarily responsible for the company's earnings. King Digital generates revenue by selling virtual items to a subset of players "who wish to enhance their entertainment experience," the company stated in its IPO filing with the Securities and Exchange Commission.

Those virtual items are extremely profitable.

During 2013, King Digital generated nearly $1.9 billion in sales and GAAP net income of $567 million. Non-GAAP metrics like gross bookings and adjusted earnings before interest, taxes, depreciation, amortization (EBITDA) came in at $2 billion and $824 million, respectively, in 2013, representing adjusted EBITDA margins of 44% for the year.

By almost any measure, those earnings are impressive and especially so when compared against the financial position of the mobile gaming, social networking and e-commerce IPOs in recent years. But King Digital's lack of diversification and the vulnerability of the company's most profitable games to being passing fads, presents a risk for investors.

Is Candy Crush a Fad?

King Digital doesn't use the word "fad" in its prospectus; however, risk factors discussed by the company highlight such risks.

In the fourth quarter of 2013, King Digital's top three games -- Candy Crush Saga, Pet Rescue Saga and Farm Heroes Saga -- accounted for 95% of the company's total gross bookings, with Candy Crush Saga accounting for 78% of total gross bookings. Furthermore, Candy Crush was responsible for 86% of mobile bookings and 58% of desktop bookings. The company also makes the Papa Pear and Bubble Witch  games.

"In future periods, we expect Candy Crush Saga to represent a smaller percentage of our total mobile channel gross bookings as we diversify our mobile game portfolio. If the gross bookings of our top games, including Candy Crush Saga are lower than anticipated and we are unable to broaden our portfolio of games or increase gross bookings from those games, we will not be able to maintain or grow our revenue and our financial results could be adversely affected," the company warned prospective investors.

King Digital, of course, believes that it can develop new games and has a strong track record.

"As of December 31, 2013, we had a massive network of 324 million monthly unique users and a track record of long-term retention driven by game longevity and our proven ability to cross-promote new games to our audience," the company said.

But if King Digital's audience is as "massive" as the company stated, its fantastic earnings appear to come from just 12 million users.

In December 2013, an average of 128 million daily active users played King Digital's games more than 1.2 billion times per day. Put another way, the average daily active user played King Digital's games 10 times a day.

One way of looking at the figure is to say that the company's engagement relies upon addicted users. But that's just the tip of the iceberg.

"A relatively small portion of our player network accounts for a large portion of our revenue. For example, during the month of December 2013, approximately 4% of our monthly unique users (MUUs), or approximately 12 million monthly unique payers (MUPs), purchased virtual items from us," King Digital stated in its prospectus.

Put another way, at a $7.6 billion valuation, each paying King Digital user would be value at about $633 apiece, many multiples of Facebook, Twitter or LinkedIn (LNKD).

"If we are unable to continue to offer games that encourage these customers to purchase virtual items, if these players do not continue to play our games, or if we cannot encourage significant additional players to purchase virtual items in our games, we would not be able to sustain our revenue growth rate, and our business would be harmed," King Digital said.

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