Price-Sales Ratios of Mobile Gaming Companies

Published by Seeking Alpha 3-20-14

Investing in publicly-held mobile gaming companies is the purest play ever on the hit-making business. It is momentum investing on steroids. To paraphrase the Sean Parker character played by Justin Timberlake in the movie The Social Network, “A doubling of sales isn’t cool. You know what’s cool? A tenfold increase is cool.”

As an example of the new cool, consider the following numbers from a Wall Street Journal article on the upcoming IPO of King Digital Entertainment (KING), the creator of the smash hit “Candy Crush Saga”,

“In its filings with the U.S. Securities and Exchange Commission on Tuesday, the game developer said it saw a more than tenfold revenue increase in 2013, as sales skyrocketed to $1.88 billion from $164 million in 2012… King said its net profit last year was $568 million, up from $7.8 million.

Jim Cramer thinks KING is cool, saying it is a better value now that Zynga (ZNGA), given the IPO’s price-earnings (P/E) ratio of 13 and a trailing twelve month price-sales (P/S) ratio of 3.7, both of which are better than ZNGA.

But, when it comes to momentum investing, trailing P/E and P/S ratios fail to capture growth potential and value. With traditional momentum investing, forward ratios are developed by projecting metrics forward, often linearly, from results of the past 3 to 8 quarters. But, coming up with a good forward ratio is problematic for mobile gaming companies where growth is hyperbolic, but can stop on a dime.

Investing in publicly-held mobile gaming companies is the purest play ever on the hit-making business. It is momentum investing on steroids.

Ignoring the possibility of stagnation, Pamela Peerce-Landers published an article in SA last week which did project out KING’s financials a few years based on the full 2013 results. The result was that Pierce-Landers values KING between $128 and $142 a share.

Multi-year projections like this based on full year results might be fine for momentum companies with moats like IP, network effects, brands, etc. But is this kind of projections valid for mobile gaming companies?  In her article, Pierce-Landers makes the argument that KING has a “formula” or “platform” that can replicate hits.  We shall see.

What follows is an analysis representing a middle ground between trailing ratios and forward ratios based on full year results.  Basically, we are saying that with mobile gaming companies, you can only look at one quarter back and one quarter forward.

What follows in an analysis of P/S ratios of 6 publicly-held mobile gaming companies plus pre-IPO KING. We also calculate
the latest quarterly sequential sales growth rate and map this against trailing P/S as a reasonable projector for companies whose growth can, and have, stopped on a dime

Several things are notable for us: (1) the sudden stagnation of KING in the latest quarter after 2 previous quarters of 50% plus sequential growth; (2) the breakout of GLUU in its latest quarter after 2 previous quarters of stagnation; (3) the lack of visibility still for a ZNGA turnaround; and (4) last, but not least, the amazing, unabated growth of the Colopl which makes KING’s growth seem pedestrian by comparison.

Next we calculate the P/S ratios for these 7 companies and plot P/S ratios against last quarter’s sequential growth rates.

The analysis suggests a positive correlation between P/S ratios and the latest quarter’s sequential growth rate.

You cannot say that a company is overvalued or undervalued based solely on its trailing P/S ratio. You must look at both P/S ratios and recent sales growth figures. You cannot say that companies like DeNA or GREE are undervalued just because their P/S ratios are less than 2 because their sales are in decline.

Similarly, you cannot say that Colopl is overvalued with a P/S ratio of 13 because its sales have been growing at 50% plus sequentially for not one quarter, but three quarters. Indeed, even with a P/S of 13, we think that Colopl is undervalued.

In the case of KING vs ZNGA, our analysis supports Jim Cramer’s assessment that KING is a better play than ZNGA. But, GLUU bests both as it has about the same P/S ratio, but sports a breakout quarter of 60% sequential sales growth rate.