Investors seeking a pure play on the mobile gaming space will find that King Digital Entertainment (KING), Zynga (ZNGA) and Glu Mobile (GLUU) offer a chance to ride a rapidly growing global market, of which is expected to reach $23.9 billion by 2016.
At a 27.3% CAGR projected for the next two years to reach $23.9 billion, revenue growth generated from games played on smartphone and tablet platforms will most likely continue to lure investors who have become leery of the richly-priced S&P, which currently trades at a historically very low 2% dividend yield.
But the downside to the space is the added risk. The two big boys in the space, King and Zynga are companies in transition, while the third player, GLUU, is a small cap.
And adding further uncertainty to the stock which make up this space, these companies don’t come with the luxury of a barrier to entry. A micro-cap enterprise can take on a behemoth at any time in mobile gaming, as King Digital’s splash hit Candy Crush Saga and Zynga’s Farmville of June 2009 have shown quite convincingly in the recent past.
In essence, Goliaths King and Zynga won’t necessarily shield investors from the David pipsqueaks. Not unlike many small pharmaceutical companies with evolutionary drugs that have snatch market share from big pharma, King and Zynga face similar threats from small-caps in the mobile gaming space.
With that in mind, let’s present a quick executive summary of each of the three focus stocks.
King Digital Entertainment
Starting with King, the largest market cap of the three, $5.02 billion, investors are faced with a company scrambling to offset a revenue decline of its one-hit wonder Candy Crush Saga – the one-hit-wonder that allowed King to muscle in on rival Zynga as well as to provide an impressive balance sheet and narrative to launch its IPO in April.
Down from 78% of total gross bookings for Q4, to 67% for Q1, Candy Crush’s performance metrics were conspicuously missing from the company’s most recent Form 6-K.
As a general rule, that’s not a good sign.
King knows it’s a one-hit-wonder stock (or at least knows that’s the perception with Wall Street analysts), and investors are anxious to see if a fair comparison can be made between the decline of Zynga’s once one-hit-wonder Farmville and Candy Crush.
Therefore, we must assume King could be in some trouble on the revenue side in coming quarters. The company’s bullpen titles, Farm Heroes Saga and Pet Rescue, need to replace much of Candy Crush’s revenue drop-off, and then some, to continue growing revenue at such a torrid pace. And that’s not likely.
And at a dismal 1% revenue growth in Q1 (sequentially), compared with year-over-year revenue growth of 195%, King, instead, approaches stall speed. Replacing Candy Crush’s $1.5 billion revenue bonanza will take some time or lots of luck.
The easy-money honeymoon appears to be over for King, as the hard work and added SG&A costs of replacing expected declining revenue from Candy Crush won’t help the company’s gross margin, operating margin or net income in coming quarters.
Since the IPO, the talk on the Street is: King Digital will experience what Zynga experienced after launching its IPO. And so far, investors have already made that assumption.
And at a trailing P/E of 7.89, investors have decided to shoot first and ask questions later. The share price of King Digital has dropped nearly 30% from its IPO of Mar. 26.
Zynga, investors’ ‘first love’ of mobile gaming, is now in turnaround mode from its approximately 87% nosedive in its stock in 2012.
Since bottoming at $2.09 in Nov. 2012, Zynga’s stock has been in an upward trend following signs that the company’s shares would benefit by a leaner payroll, new management, a strong focus on mobile game apps (and away from its Facebook model), a $200 million stock buyback program, and the purchase of the talented staff at 3D-animation company, NaturalMotion.
In Q1 of fiscal 2014, Zynga reported 123 million average monthly users, a drop of 51.3%, year-over-year.
Revenue for Q1 was driven by the popularity of the sequel to Farmville, Farmville 2: Country Escape, according to Zynga’s 10-Q ended Mar. 31.
CEO Don Mattrick’s strategy to franchise Zynga’s game lineup – a strategy that worked well during his career at Electronic Arts – appears to be working again at Zynga. The mobile audience for the Zynga Poker franchise jumped 19%, sequentially, the first sequential increase in bookings since Q2 of 2012. Daily Active Users (DAU) for Words With Friends, another developing franchise, rose 9% from Q4 of 2013 and spiked 43% in bookings, year-over-year.
Unlike King Digital’s reliance on its single hit, Candy Crush, Zynga’s game lineup include Farmville 2, Zynga Poker, and Farmville, of which comprise 30%, 24% and 10% of total revenue, respectively. And that doesn’t include potential hits from NaturalMotion’s very popular CSR Racing and Clumsy Ninja. These two budding franchises are expected to be accretive in coming quarters.
Though Zynga still operates at a loss – a condition expected by Mattrick to continue until fiscal 2015 – the company still has $910 million of short-term assets to sustain itself through the transition period.
Mattrick’s franchising strategy in the midst of an increasingly competitive gaming space may actually work given the impressive results demonstrated so far with Zynga Poker and Words With Friends during Q1.
And with the addition of NaturalMotion, future titles in 2015 will include 3D animation unparallelled in the space and will go a long way in repairing the Zynga brand from early faux pas in 2012, when it abruptly canceled several games to the dismay of loyal players.
The takeaway from the comparison between the two leaders of the sector can be summed up by pointing out the vulnerability inherent of a company with one big-hit title; it’s not much different from a business relying upon one large customer for its revenue. It’s a dangerous and potentially catastrophic position to operate in.
Therefore, on balance, investors may remain squeamish with King’s single franchise while it works to deepen its pen of hit candidates. In contrast, Zynga is further along in the process of diversifying and franchising, and is therefore favored among the two giants.
Glu Mobile, the small cap among the three pure plays in the mobile gaming space, is the most exciting addition to the mobile gaming space.
Glu’s Q1 results indicate faster revenue growth than anticipated by Wall Street analysts. With the finely executed deployment of the company’s popular games, Deer Hunter and Eternity Warriors, revenue soared 90% to $47 million, year-over-year, smashing analysts’ mean estimate of $39.5 million.
Glu’s operated at a non-GAAP profit in Q1, from a non-GAAP year-over-year loss of $5.8 million. The company earned $0.06 per share against analysts’ mean estimate of $0.02.
Guidance for fiscal 2014 revenue was raised to a range of $155 million and $161.5 million, up from previous guidance of $142 million to $150 million. Glu expects to earn between $0.02 and $0.03 per share, approximately inline with the mean analysts’ estimate.
Just as investors look to King and Zynga for a diversified portfolio, Glu investors saw 58.3% of the company’s total revenue coming from Deer Hunter and Eternity Warriors. Not bad, but at least one more title would be better, of course.
However, Glu’s Robocop reached 7.4%, just short of the arbitrary 10% barrier considered to be the threshold of inclusion to a meaningfully and more predictable revenue producer and candidate for sequels.
In addition, smaller titles such as Contract Killer 3, Hercules, Tap Sports: Basebell, along with Glu’s recent purchase of PlayFirst’s games, Diner Dash, Cooking Dash, Wedding Dash, and Hotel Dash will most likely keep the company reasonably diversified, deep and revenue-steady for at least through to 2015.
No doubt, Glu’s business model works. The company is broadening its titles and making appropriate acquisitions. It has $54.4 million in current assets, apparently good management and no debt.
Everything looks rosy for Glu, but for one thing. Investors taking a position in Glu, today, will be paying 26-times earnings for the shares. With revenue expected to jump another 40% during fiscal 2014, Glu’s PEG ratio already stands at a nosebleed 28.9.
Though the rate of growth in the global mobile gaming space will be rapid, with all three companies exploiting the fastest growing markets of Asia, each company navigates its own particular set of challenges. King must broaden its take of winners. Zynga needs to continue rightsizing and executing its branding strategy. And Glu needs to continue the success it has enjoyed. Expectations are rather high for Glu, and one disappointing earning report could crater the stock.
Of the two giants, Zynga is preferred over King because of Zynga’s depth and breadth of title. Additionally, Zynga’s acquisition of NaturalMotion could turn out to be the most important acquisition of the company’s history, as the team at NaturalMotion is able to provide a 3D animation experience that other game makers cannot offer at this time. But we will not see the results of this synergy until 2015.
And Glu, though it trades at a rich multiple to projected earnings, the company has all the makings of a takeover candidate. Since the mobile gaming market offers a high gross margin and an eye-popping market growth profile, Glu’s continued excellent performance could be attractive as a means of a much larger suitor grabbing market share.
Disclosure: I am long GLUU.