Gaming Fever Catching?

 | Mar 12, 2014 | 5:00 PM EDT  | Comments
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King Digital plans to go public by the end of this month.

The maker of the popular Candy Crush game is hoping to achieve a valuation of $7.6 billion when it does, according to Bloomberg. That's at the high end of the offering price, which its underwriters are currently floating. That doesn't mean that it'll get that price. But if Twitter's (TWTR) IPO is anything to go by, it will probably be higher than that.

There's a dance that goes on when pricing an IPO. The price being floated has to be low enough that it whets the appetite of big institutional buyers who the underwriters are hoping to entice to buy into the offering. In the ideal scenario, the interest in a hot IPO starts building weeks before. And the price talk keeps going up as the IPO gets closer and closer.

That's just what happened with Twitter. The first price talk started around the low teens, then it was the high teens and then it ended up at $24 for the IPO. Of course it's doubled from there, now trading at $55.

It doesn't always work out. Chegg (CHGG) priced at $12.50 a share and then opened lower and now trades in the $6s.

Many people are skeptical of King's IPO, mainly because it reminds them of Zynga (ZNGA) and the way that that stock has dropped over the last couple of years as the shift to mobile gaming occurred. This overlooks the fact that Zynga actually traded above its IPO price for many months after the IPO, at one point getting to $14 before the effects of the mobile gaming shift really started to be seen.

In King's case, it's already squarely a mobile company. But the critics like to point out that 80% of its revenues come from one game. Having to deal with a mega-hit is a good problem to have. It's like criticizing Apple (AAPL) for having too big a hit on its hands with the iPhone.

But from today's Bloomberg article, it doesn't appear that potential King IPO investors are fazed. They seem comfortable with a $7.5 billion valuation on a business that did $1.8 billion in revenue last year and $714 million in EBITDA.  That's a 4.1x price-to-trailing-sales ratio.

Zynga's ratio (on a trailing basis) is 5.6x and Glu Mobile's (GLUU) is 3.8x.

Nevertheless, both Zynga and Glu have been moving up in recent days. Why?

I think it's because King Digital is likely to get a higher valuation than just $7.5 billion. I'm not sure it will be double this initial talk, the way Twitter was. Let's say it's 50% higher. That would take it to a $11 billion valuation. Then, assume the IPO underwriters do their job and it trades up another 15% higher from there. Now you're talking about a $13 billion valuation.

At that level, King would have a 7.2x trailing price-to-sales level. This would imply that both Glu and Zynga are undervalued in comparison when viewed against King.

Now, some of the more mainstream console gamers like EA (EA) and Activision Blizzard (ATVI) are still priced on a lower price-to-sales basis. EA is at 2.5x and Activision is at 3x. But if the market judges that pure-play mobile gamers deserve a premium compared to the console gamers, Zynga and Glu should benefit in the near term.

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