COLUMN-Candy Crush and the moat fallacy: James Saft

Thu Mar 13, 2014 4:03pm EDT

By James Saft

March 13 (Reuters) - A game involving "moving candies to make a line of three in the same color" seems like an excellent basis for a $7.6 billion IPO to me.

That game is 'Candy Crush,' which is the principal ornament and money maker of King Digital Entertainment, a Dublin-based company planning a share offering this month.

Seems like they have really hit the sweet spot with Candy Crush.

I mean two candies of the same color in a row, well that would just be stupid. And if Candy Crush required people to do four it would be limiting the market unnecessarily to players with good spatial skills.

Now unlike Instagram, with virtually no profits, or Facebook , trading at a trailing P/E of 115, the valuation issue with King isn't quite so outrageous, with an implied trailing P/E of just 13.

Those solid earnings are mostly courtesy of Candy Crush, which has spurred King to a 28-fold revenue growth to $602 million from the first quarter of 2012 to the final quarter of 2013.

As King relies extensively on income from its one big viral hit, Candy Crush, it is dependent on its ability to sustain that hit or replicate others.

There can be no assurances that there will be another, or, if any others take off, that they grow as quickly. After all 10 people created Candy Crush. This isn't an auto plant, or even a restaurant franchise. The barriers to entry are low and getting lower all the time. Design an attractive and addictive game and you'll be up against growing competition which can do the same, and has the marketing budget to back it up.

And while you might compare these game companies to a casino, with complex engineering to keep people playing and tempt them to buy upgrades, the fact is that it is a virtual casino, or game, and that means competition is pretty much infinite.

DRAINING THE MOAT

This brings us to the basic misunderstanding underlying most over-valuations of Internet-enabled businesses: the moat fallacy.

It isn't that moats, a defensible barrier around a profitable franchise, don't exist, but rather that we are applying a standard, learned in the 150 years after the first industrial revolution, which assumes that moats are far deeper than they are today.

We look at a company and we subconsciously assume, from generations of observation, that replacing or displacing it will be hard, like it was hard to start a steel company or a bank.

But companies whose business is enabled mainly by the Internet are far, far less entrenched than might have been a manufacturer with a factory, a supply chain and an established brand. Facebook has a valuable network but the rise of WhatsApp only demonstrates that networks are perhaps easier to build than we thought. Candy Crush is a successful game, but the Internet awards no franchises.

We tend to make further assumptions about brands, giving them similar credence when they belong to a company with a large market position on gaming or social media that we might have done in former days to Buick or Whirlpool.

That kind of brand loyalty, however, though it is still hardwired into our world view, is a relic of the time before the Internet, a trend very interestingly discussed in The New Yorker recently by James Surowiecki. ()

As search and research becomes easier, brands and market position diminish in value.

One of the implications of this is that anyone with territory to defend in the virtual world is going to engage in a fierce marketing battle with new entrants. For established brands that can only ever be a rearguard action against a secular decline in brand value. For new entrants that marketing budget is a crap shoot, albeit with some huge possible payoffs.

King's $100 million per quarter marketing budget might prove insufficient, or might end up a regrettable sunk cost.

That's great news, at least for a time, for marketing professionals, but less good for shareholders.

If you are Facebook or Candy Crush, the value of your market position and brand is far less than it would have been before the Internet, the very development that made you possible. That's increasingly true for General Mills and Whirlpool too, but the valuation risk is perhaps a bit less.

There will be winners, maybe even King Entertainment, who knows. But in aggregate this is, if not a bubble, a serious structural over-valuation.