King Digital Entertainment

• The Bottom Line: King Digital Entertainment, the creator of Candy Crush Saga, serves as a masterclass for value investors on the critical difference between a spectacularly profitable fad and a truly durable business.
• Key Takeaways:
• What it is: A mobile gaming company that achieved phenomenal global success and profitability driven almost entirely by a single blockbuster game, Candy Crush Saga.
• Why it matters: Its story is a cautionary tale that perfectly illustrates the dangers of investing in “one-hit wonder” companies that lack a durable competitive advantage, or "moat".
• How to use it: Analyze the King case study to develop a “litmus test” for identifying businesses with unsustainable revenue streams and to reinforce the discipline of investing only with a sufficient margin_of_safety.

Imagine a band that releases a song. It's not just a hit; it's a global anthem. It's played on every radio station, in every store, and hummed by billions of people. The money pours in, turning the band into overnight multimillionaires. This, in essence, was King Digital Entertainment. Their smash hit song was a deceptively simple mobile game called Candy Crush Saga. Released in 2012, Candy Crush wasn't just a game; it was a cultural phenomenon. It hooked hundreds of millions of players with its addictive “match-three” puzzle formula. King employed a brilliant business model known as “freemium.” The game was free to download and play, which allowed it to spread like wildfire. The revenue came from “microtransactions”—small, voluntary payments made by players for things like extra lives, special powers, or access to the next level. Think of it like an amusement park with free admission. You can walk around all day and enjoy the sights, but if you want to ride the best roller coasters or get some popcorn, you have to pay. When you have 500 million people in your park, even if only a tiny fraction buy popcorn, you can make an astronomical amount of money. And King did. At its peak, the company was generating billions of dollars in revenue and hundreds of millions in profit. This immense success led to a highly anticipated Initial Public Offering (IPO) in 2014, where the company began selling its shares to the public. However, the story took a sharp turn. Many professional investors were skeptical, asking the same question they'd ask of that one-hit-wonder band: “That was a great song, but can you do it again?” In 2016, King was acquired by the video game giant Activision Blizzard for $5.9 billion. While this provided a payday for its investors, it also marked the end of its journey as an independent company, cementing its legacy as one of the most memorable—and educational—business stories of the 21st century.

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” - Warren Buffett

For a value investor, the story of King Digital Entertainment isn't about a fun game; it's a profound lesson in risk, value, and the nature of a great business. A value investor's goal is to buy wonderful companies at fair prices, and the word “wonderful” implies durability, predictability, and resilience. King, for all its dazzling profitability, struggled to meet this standard. Here’s why its case is so crucial:

• The Ultimate Moat Test: The most important concept for a long-term investor is the economic moat—a unique structural advantage that protects a company from competitors, much like a moat protects a castle. King’s moat was shallow at best. While the Candy Crush brand was powerful, the underlying business was vulnerable. Players could easily switch to a new, free game with zero cost or hassle. This is the polar opposite of a company with a deep moat, like American Express, whose customers face high switching costs, or a railroad like BNSF, which has physical assets that are impossible to replicate. King had a hit product, not a protected fortress.
• The Peril of Unpredictability: Value investing is a discipline of probabilities, not certainties. We try to estimate a company's future earnings and cash_flow to determine its intrinsic_value. With a company like Johnson & Johnson, you can reasonably predict that people will still be buying bandages and Tylenol in ten years. With King, how could you possibly predict if they would ever create another game as popular as Candy Crush? Their future earnings were a giant question mark. This extreme unpredictability makes a rational valuation nearly impossible, turning an investment decision into a speculative gamble.
• A Lesson in Staying Within Your Circle of Competence: Warren Buffett famously avoids industries he doesn't understand, particularly fast-changing technology sectors. The mobile gaming industry is a perfect example. It's defined by shifting tastes, technological disruption, and hit-or-miss dynamics. For most investors, it's a minefield. The King saga reminds us of the wisdom of sticking to simple, understandable businesses whose futures are at least reasonably foreseeable.
• The Market Can Be Rational: While we often talk about “Mr. Market” being irrational, King's IPO tells a different story. The company went public at $22.50 per share and promptly fell over 15% on its first day of trading. This wasn't panic; it was a cold, hard assessment by the market. Investors looked at the massive profits, then looked at the source of those profits (one game), and correctly concluded that the business risk was extraordinarily high. The initial stock price failed to provide a margin_of_safety for the inherent uncertainty, and the market adjusted accordingly.

In short, King Digital is a poster child for the type of business that value investors typically avoid: flashy, wildly profitable in the short term, but built on a foundation of sand rather than rock.

The story of King Digital Entertainment isn't just a historical anecdote; it provides a powerful mental model you can use to analyze other companies. Think of it as the “King Digital Litmus Test” to screen for businesses that rely on fleeting success rather than durable advantages.

When you're analyzing a potential investment, especially one enjoying a wave of popularity, ask yourself these four questions:

1. Step 1: Identify the Cash Cow.
   • What is the single product, service, or intellectual property that generates the vast majority of the company's profits? Be specific. Is it a patented drug, a specific software suite, or a hit video game? For King, the answer was unequivocally Candy Crush Saga and its variations. If over 70-80% of profits come from one narrow source, a red flag should go up.
2. Step 2: Assess Its Durability (The Moat Question).
   • Now, critically examine that cash cow. How permanent is its appeal? Ask:
   • Switching Costs: How hard is it for customers to switch to a competitor? For Candy Crush players, it was as easy as downloading another free app. For a bank's business clients, switching is a complex and costly headache.
   • Fad vs. Staple: Is this product a discretionary “want” that is subject to changing tastes (like a trendy game), or is it a recurring “need” (like toothpaste or electricity)?
   • Competitive Landscape: How easily can a competitor replicate this product's success? The app stores are littered with thousands of Candy Crush clones. It's much harder to build a new global payment network to compete with Visa.
3. Step 3: Look for the Next Act.
   • A great management team knows that a single success is not a strategy. What are they doing with the mountain of cash generated by the hit product?
   • Are they reinvesting it to create a second, third, and fourth durable revenue stream? Or are they simply trying to catch lightning in a bottle again? King acquired other studios and developed other games, but it never managed to create another success on the same scale. Look for evidence of intelligent capital_allocation that builds a wider, more resilient business.
4. Step 4: Demand a Steep Discount (The Margin of Safety).
   • If a company shows red flags in the first three steps—its profits come from one source, that source isn't very durable, and there's no clear “next act”—a value investor shouldn't necessarily dismiss it outright. However, the risk is now glaringly obvious. To compensate for this risk, you must demand an enormous margin_of_safety. The price you pay must be so ridiculously cheap that it accounts for the high probability of the main profit engine eventually sputtering out.

By running a company through this test, you can quickly categorize it. Does it look more like King Digital—a brilliant but fragile one-trick pony? Or does it look more like a company like Coca-Cola, which has a portfolio of durable brands that have slaked the world's thirst for over a century? A “pass” on this test doesn't guarantee a great investment, but a “fail” is a very strong signal to be extremely cautious. It tells you that you are not looking at a stable, predictable business, but rather a high-stakes bet on continued, fleeting popularity. For a value investor, that's a game that's rarely worth playing.

To truly grasp the lessons from King Digital, let's compare it to a business that Warren Buffett famously loves: See's Candies. At first glance, they both sell “candy,” but from a value investor's perspective, they exist in different universes.

This comparison is the heart of the matter. King offered the potential for explosive growth, but with enormous risk and uncertainty. See's Candies offers certainty and moderate, predictable growth. A value investor will almost always choose the predictable certainty of See's over the speculative allure of King.

It's important to analyze the King Digital business model in a balanced way. Its structure had both incredible strengths and fatal flaws.

• Explosive Profitability: When a hit strikes in the digital world, the financial results can be breathtaking. With minimal marginal cost to serve a new user, a popular game or app can become a pure cash machine, generating margins that industrial companies can only dream of.
• Incredible Scalability: A physical product company needs more factories and raw materials to grow. King Digital could serve one hundred million new players almost as cheaply as it could serve the first million. This frictionless scalability is the holy grail of modern business.
• Viral Marketing: In its early days, Candy Crush grew through word-of-mouth and social media integrations, creating a powerful and free marketing engine that brought in millions of users without expensive advertising campaigns.

• The One-Hit Wonder Risk: This is the single greatest weakness and the defining characteristic of this business model. The entire financial structure rests on the fragile pillar of a single product's popularity. When the pillar cracks, the whole building collapses.
• Absence of a True Moat: As discussed, brand recognition for a single product is not a moat. Without high switching costs, network effects, or other structural advantages, competitors are always at the gate, ready to lure away your customers with the next big thing.
• Inherently Unpredictable Future: It is almost impossible to build a rational financial model for a company whose main task is to “create the next hit.” Creativity is not a predictable input. This makes calculating a reliable intrinsic_value an exercise in futility.
• Escalating Customer Acquisition Costs: Once the initial viral growth slows, the company must spend enormous sums on marketing and advertising to attract new users and keep existing ones engaged. This “marketing treadmill” can quickly erode the once-spectacular profit margins.

• durable_competitive_advantage: The core concept that King Digital lacked, representing a business's ability to fend off competition over the long term.
• margin_of_safety: The essential buffer required when investing in any business, but especially one with as much inherent risk and uncertainty as King.
• circle_of_competence: The principle of only investing in businesses and industries that you thoroughly understand; the mobile gaming sector is outside this circle for most investors.
• speculation_vs_investing: The King IPO was a textbook example of an offering that appealed more to speculators (betting on future hits) than investors (analyzing a durable business).
• intrinsic_value: The underlying worth of a business, which was exceptionally difficult to calculate for King due to the unpredictability of its future cash flows.
• business_model_analysis: The process of dissecting how a company makes money, for which King's “freemium” model is a fascinating and important case study.
• Initial Public Offering (IPO): Understanding the risks of buying into a company at its IPO, where hype can often overshadow a rational analysis of the underlying business.