Is King Digital's Candy Crush IPO Too Good to Be True?

Corrected from 1:59 p.m. ET to remove stock ticker of Rovi Corporation.

NEW YORK (TheStreet) -- King Digital Entertainment, maker of the popular mobile game Candy Crush Saga, generated $4.38 in diluted earnings per share in 2013, meaning that as the company seeks to list its shares on public stock markets it may carry a more palatable valuation than recent high-profile IPOs such as Twitter (TWTR), Facebook (FB), Zynga (ZNGA) and Groupon (GRPN). 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 the company's linchpin FarmVille game. King Digital, by way of its addictive Candy Crush Saga game, faces a similar risk, if not, magnified risks for investors.

King Digital's current business model goes as follows: The company offers mobile and desktop gamers its popular games for free, meaning that King Digital's over quarter billion user base 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 F-1 IPO filing with the Securities and Exchange Commission.

Those virtual items are extremely profitable.

In 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 to possibily its most profitable mobile games may turn into a fad presents a risk for investors.

Is Candy Crush a Fad?

King Digital doesn't use the word "fad" in its F-1 IPO filing; 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.

"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 F-1.

King Digital may have a massive audience. Its earnings are derived from a small subset of the company's user base.

"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 stated.

Furthermore, King Digital is filing for an IPO after an unprecedented rise in its business. After all King Digital's revenue grew over tenfold between 2012 and 2013. In the fourth quarter, its monthly active users grew to 408 million, or about 509% from year-ago levels. However, sequentially the company's users only grew 13% from the third quarter of 2013 to the fourth quarter of 2014.

King Digital's growth could be slowing markedly as it seeks an IPO. Currently, the placeholder for the IPO is set at $500 million. JPMorgan, Credit Suisse and Bank of America are leading the offering with another 10 underwriters also referenced in F-1 materials.

Those are just two risks for investors to consider before contemplating buying King Digital's shares in an IPO.

Competition, App Store Reliance

Other risks include high competition in mobile gaming from Zynga, Electronic Arts (EA), Rovio, Tencent and the like, in addition to software and hardware giants like Amazon (AMZN), Apple (AAPL), Google (GOOG), Disney (DIS) and Yahoo (YHOO), another risk factor disclosed in the F-1.

On the other hand, King Digital's track record currently speaks for itself. The company only raised $9 million of primary capital since inception and has generated positive cash flow from operations for each of the last nine years.

"We believe we have a repeatable and scalable game development process that is unparalleled in our industry. In the last decade, we have developed a catalog of more than 180 game IPs, which we continuously expand," the company stated.

Investors buying into King Digital's IPO and valuing the company using current earnings figures will have to hope that its track record can be matched when it hits stock markets.

Zynga's plight and the similar boom and bust fad cycles of other popular games are cautionary tales for investors to consider.

-- Written by Antoine Gara

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