By James Saft
March 13 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
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
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
DRAINING THE MOAT
This brings us to the basic misunderstanding underlying most
over-valuations of Internet-enabled businesses: the moat
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