Name That Trade – $KING: Hard Candy

by Dan September 8, 2014 2:37 pm • Commentary

My friend David Seaburg, head of Sales Trading at investment bank Cowen & Company, hit me up with an idea on a stock that has been off our radar – King Digital Entertainment (KING), maker of free causal mobile social games like Candy Crush.

Enis and I decided to take a closer look at the name, which despite its short trading history as a public stock has a couple potentially trade-able events in the near future.

Let’s start with the technical set up. Since KING’s March IPO, the stock has traded below its IPO price of $22.50 except for a brief push in early July:

KING chart since March IPO Bloomberg
KING chart since March IPO Bloomberg

The stock got slammed on its August 12 earnings report, after Candy Crush user and revenue growth slowed down, and the company had to cut its 2014 revenue forecast by more than 10%, from $2.55-$2.65 billion down to $2.25-$2.35 billion.

However, the stock is very cheap on a valuation basis, trading at a P/E of only 7.5, an a EV/EBIT of around 4.75 and about 2x 2014 sales. The concern, though, is that the long-term viability of KING’s business is too dependent on Candy Crush, especially after disappointments for late investors of Zynga (Farmville hit) or Rovio (Angry Birds hit). Also, regulators are currently cracking down on in-app purchases and that will likely force company’s like KING to rethink their revenue models.

KING hardly has a wide moat, though there is value in the company’s branded games from a recognition standpoint. But the company gives the games away for free and makes its revenue on selling virtual items, points, and access to new levels.

The valuation discounts a lot of the bad news at this juncture.  Yet, there is one more reason that investors have not been enthusiastic to buy KING after its plunge last month – the end of its lock-up period for pre-IPO investors.  BI detailed that concern in an article after earnings:

There’s also the matter of the company’s post-IPO lock-up expiration.

On Twitter, CNBC’s Carl Quintanilla, citing comments from analysts at Pacific Crest, said that 93% of King Digital shares are impacted the Sept. 22 lock-up expiration that looms. A lock-up expiration is the first date that insiders can sell their stake in a company after its IPO, and so this dividend could be seen as a way to keep investors in from selling their stake.

In its earnings release, King Digital added that: “In addition, the Company’s executive officers, directors, founders, and affiliated funds, including Bellaria Holding S.a.r.l of whom Apax WW Nominees Ltd is the sole shareholder, together representing 80% of outstanding shares, have agreed to a new lock up with the Company through the date following the Company’s announcement of fourth quarter and full year 2014 earnings.”

The read-through on this announcement could be that the company expects the remaining 13% of shares impacted by the lock-up expiration to be sold into the market.

If the remaining 13% of shares were indeed for sale after the IPO, that would be about 40 million shares, or nearly twice the stock’s current float.  Our hunch is that the 60% short interest (which would fall to about 20% if those shares join the float) represents many traders who have been anticipating buying back their short from investors who sell on the lockup.

Back to Seaburg of Cowen and his firm stance on the stock.  Their analyst Doug Creutz rates the stock a Buy with a 12 month price target of $27 (there are 5 buys on the stock, 8 holds and no sells), more than 100% above current levels. In a research note to clients on Sept 5th, Creutz stated the following:

Over the past few weeks, the U.S. chart performance of King’s titles has noticeably improved. This suggests that the negative seasonality King identified on its Q2 earnings call has reversed, suggesting potential upside to Q3 estimates


Aside from Candy Crush Saga (which is more or less permanently embedded in the #2 chart spot), five of King’s six mobile titles have risen in the U.S. iPhone top-grossing rankings over the past three weeks.


If the end of seasonality means a return to the ‘normal’ decline trendline for King’s mature titles, i.e. average q/q declines in the low-double digit range instead of the 20%+ implied in King’s guidance, then we think there could be significant bookings upside in Q3 based on what should be a much stronger performance in September vs. the July-August run-rate.

So obviously fairly bullish, and given the stock’s poor performance (4% from the all time lows and 43% below the all time highs) over the last month, this call is out of consensus with analysts and investors alike.  I suppose the impending lock-up is weighing on shares, and as TWTR’s May lock-up showed investors, when recent IPOs are out of favor, there is no way to gauge a bottom in the face of massive supply.

Seaburg’s option’s desk at Cowen last week suggested a bullish trade to clients who think the shares are washed out and agree that a potential Q3 revenue uptick could be revealed on their next earnings (that should fall in November expiration).  That defined risk bullish bet was long the Nov 14 calls for about 1.05, suggesting a break-even at 15.05, or about about 11%.

Looking at the 30 day at the money implied vol (IV), it appears that options prices are right near the lows, and down massively from their pre Q2 earnings gap:

30 day implied volatility in KING, courtesy of Bloomberg
30 day implied volatility in KING, courtesy of Bloomberg

It’s important to note that IV is still in the high 40s and very high relative to many tech peers.  I would also note that options prices are wide in terms of bid ask, and liquidity is not exactly stellar with only 91,00o total open interest. For comparison sake, Pandora, which has a market cap of $5.4 billion vs KING’s $4.2 billion, has open interest of 475,000 total.   The bottom line here is that the entry and exit in KING options is going to cost you a bit of any profit that is not a magnitude of the premium at risk, so you have to get timing and direction right.

Given the relatively high levels of IV, wide bid ask and potentially volatile events, the trade that made the most sense to us was the following:  

Hypothetical Trade:  KING ($13.40) Buy the Jan15 14/19 Call Spread for $0.95

-Buy to open 1 KING Jan15 14 Call for $1.30

-Sell to open 1 KING Jan15 19 at $0.35

Break-even on Jan15 Expiration:

-Profits of up to $4.05 with stock between $14.95 and $19, max profit of $4.05 with stock at $19 or above.

-Losses of up to $0.95 between $14 and $14.95, max loss of $0.95 at $14 or below

Rationale:  This call spread gives you more than 4 months for KING to have a bounce back to at least the first level of resistance around $16, but the initial cost is minimized by selling the $19 call.  The trade won’t decay much until after the November earnings report, so the main risk in the near-term is directional.

We decided not to pull the trigger on this trade because we are concerned that the Q2 earnings miss and lower guidance is a larger issue related to monetization of mobile apps.  The entire app industry saw a weak Q2, possibly due to a crackdown on in-game payments by federal regulators across the world, as parents had been complaining about children charging large sums for the games.  As a result, we don’t feel comfortable with the long term bullish thesis unless company’s like KING can prove a sustainable pivot from in-app purchase dependence, but the trading setup is an interesting one for those who like the risk/reward of the call spread.