I get positively excited when market sentiment turns negative. Although it takes a toll on my portfolio in the short-term, it provides opportunities that increase the chances of portfolio success in the future.
One such opportunity I have begun to nibble on is King Digital Entertainment (KING), maker of Candy Crush and other games for mobile phones and social networks. The company has a P/E in the mid-single digit range, along with a cash position representing about one quarter of the company's market cap.
The reason for the market's pessimism is that the company's major hit, the aforementioned Candy Crush, appears to have peaked in terms of revenue; and when it comes to fads, what goes up comes down hard. I don't dispute that Candy Crush may be on the decline, but it looks to me like the company has a formula that will allow it to continue to capitalize on this gaming platform for years to come.
While Candy Crush is on the decline, the company's other games grew revenue sequentially by almost 20% to a $1 billion annual run-rate last quarter. (The company's enterprise value is less than $3 billion.) The company always has a few games in the top-grossing games list, suggesting they have a repeatable process that effectively monetizes games.
I downloaded and played a few games, and as a non-gamer, here's what I found. The games are somewhat addictive, and not overly-promotional in terms of generating revenue. I was surprised not to have been hit up for money after playing quite a few rounds. But here's how they do it: when you have put in a lot of work at getting through a level and just fail by a little bit, it can be disheartening to start from the beginning. One way they capitalize off of this feeling is by letting you drop $1 in order to have a shot at completing the level without starting from scratch. Only 5% of players end up as paying customers, but obviously this was enough to generate over $2 billion in revenue over the last 12 months.
I am also pleasantly surprised by the company's shareholder-friendliness and risk aversion. As a recent IPO (though now 50% lower than its IPO price) and as a tech company, I'd expect insiders to be throwing the company's new-found cash around, buying up companies in only loosely-related industries as far as the eye can see. Not so here.
Consider the structure of the company's only purchase so far, which was of another gaming company: "Total consideration for the acquisition consists of a $6 million upfront cash payment and up to $84 million of contingent consideration based upon criteria linked to revenues from games developed." The company's cash balance is over $800 million; in other words, it doesn't need to structure its deals like this, but it does so anyway. That's the kind of capital allocation I appreciate as a shareholder.
Perhaps it is the company's majority ownership (80% of shares are currently closely held, with a voluntarily-delayed lockup now scheduled to expire in about 5 months) that causes this aversion to risk. I have no problem with that, as it appears these managers are more likely to think like owners. The company also recently paid a special dividend of $200 million.
Management's philosophy towards its operations is also something I really like. The company talks a lot about testing, and touts its variable cost structure, claiming only 10% of revenue is spoken for by fixed costs. Even marketing is something that is scaled up and down and across media strictly by ROI; I wish more companies I own did this.
Finally, the company also has a tax advantage (corporate tax rate of 12.5%!) as it is domiciled in Ireland.
I wouldn't mind if this one fell further so I could pick up some more.