Unpacking the $5.9BN King acquisition price

Posted on November 9, 2015 by Eric Benjamin Seufert

Candy-crush-saga-portada

Last Monday, Activision Blizzard, the 5th largest gaming company in the world by revenue and the owner of multiple venerable franchises such as Call of Duty and Warcraft, announced that it would acquire King Digital, the developer of Candy Crush, for $5.9BN. The acquisition, pending approval from the Irish High Court and King’s shareholders, will be the largest ever for a mobile game developer. The price of the acquisition represented a 20% premium on King’s enterprise value as of October 30th and 8x its projected 2016 EBITDA (14x projected 2016 earnings).

Some facts about the deal and the companies:

– $3.6BN of the acquisition price (61% of the total value) will be paid from cash held by Activision Blizzard outside of the United States. Since King Digital is based in Ireland, Activision Blizzard can use this offshore cash to fund the acquisition without paying repatriation taxes on it (at the corporate rate of 35%, absent any foreign tax credits). When Microsoft acquired Skype (based in Luxembourg) in 2011 and Mojang (based in Sweden) in 2014, it similarly benefited, from a tax perspective, from the use of offshore cash.

– The combined company will have an “audience of 500 million players“. In its Q3 2015 earnings report, released two days after the acquisition announcement, King indicated that it reached 330MM MUU (monthly unique users) in Q3. Activision Blizzard claims that 60% of King’s users are female;

– Activision Blizzard’s net revenue increased by 31% year-over-year from Q3 2014, from $753MM to $990MM;

activision-blizzard-revenues

– King’s adjusted revenue decreased by nearly 10% over the same period (note: adjusted revenue is not the same as net revenue and is thus not directly comparable to Activision Blizzard’s net revenue figure above. For more information about the metrics King presents in its earnings reports, see the appendix to this file);

king-adjusted-revenue

– King holds nearly $1BN in cash and cash equivalents on its balance sheet (and has very little in non-current liabilities);

king-cash-position

– 83% of King’s gross bookings are generated on mobile (note: gross bookings are different from adjusted revenues);

king-bookings-by-channel

– 13% of Activision Blizzard’s net revenues (again, not directly comparable to King’s gross bookings) are generated on mobile;

activision-bookings-by-channel

– King’s adjusted EBITDA fell by 16% year-over-year from Q3 2014, to $180.4MM from $216.1MM. Profit was more or less flat, although it was highly volatile over the course of the period;king-ebitda

– As a percentage of net revenue, King’s marketing and sales expenditure remained relatively flat, year-over-year.

king-sales-marketing

Cash flows

Given that the percentage of King’s revenues generated by Candy Crush Saga fell from 60% in Q3 2014 to 49% in Q3 2014, as well as the company’s ability to keep sales and marketing at a stable percentage of net revenue, it’s not unreasonable to assume that King could continue to generate profits within some controlled range of their current levels for the next few years. The table below depicts a projection of free cash flows from King under three scenarios: flat (ie. dollar-value profit levels remain unchanged), 10% decrease quarter-over-quarter, and 20% decrease quarter-over-quarter. Note: the total amounts are not discounted.

King-FCF-2

Under the 10% quarter-over-quarter decline scenario (pessimistic, given that the company’s revenues decreased by 10% year-over-year to Q3 2015), King generates $1,015MM (again, this number is not discounted) in free cash flows through the end of 2020 (or roughly 5 years after the acquisition closes).

These cash flows, combined with the $920MM in cash and cash equivalents that King holds on its balance sheet, add up to $1.935BN. But since Activision Blizzard is using $3.6BN in offshore cash to fund the deal, it is saving $1.26BN in the repatriation taxes it would have to pay to transfer that money back to the US. Together, these amounts add up to $3.195BN, or more than half of the acquisition price for King.

Synergies, new markets, and audience

So where is the remainder of the purchase price ($2.705BN of the total $5.9BN) made up?

For starters, in acquiring King, Activision Blizzard gains access to nearly 200MM female mobile gamers (60% of its Q3 2015 330MM MUUs). With adult women being the fastest growing gaming demographic, Activision Blizzard has enabled itself to launch female-oriented IP to a massive audience through cross-promotion from King’s titles.

Access to this audience alone has immense value: were Activision Blizzard to launch a female IP — and it’s doubtful that Activision Blizzard would try to cross-promote King users to its existing portfolio to any great degree, given the demographic skew of its current mobile titles — it’d almost certainly have to spend lavishly on user acquisition. Starting from nothing, there’s no telling how much Activision Blizzard would have to pay, per user, to acquire a large female audience, especially in large numbers within a short amount of time. $8-10 per acquired user wouldn’t be out of the realm of reason for campaigns designed to quickly generate large user bases of female gamers.

Secondly, the acquisition provides Activision Blizzard with access to a large (King has more than 1,600 employees) pool of talent with a breadth and depth of experience that the company would be hard-pressed to assemble on its own outside of M&A. This talent pool comprises not just mobile product developers (although certainly King’s teams excel at making mobile-first products), but also analytics and user acquisition experts. These roles are incredibly difficult to hire for: there are only a handful of companies in the industry where one can experience the unique challenges faced in operating a Top Grossing free-to-play game.

Diversification

Putting these components together — the financial benefits of using offshore cash on an acquisition, King’s future cash flows, and access to a new audience and talented pool of employees — it seems that the price paid for King, even at a 20% premium on enterprise value, is justified.

Of course, operational risks are certainly present: can Activision Blizzard capably build female-oriented mobile IP? What happens if the erosion in Candy Crush revenues accelerates? But Activision Blizzard’s management team is considered among the gaming industry’s best, and it has a strong track record of making acquisitions work.

The combined company will have a diversified portfolio across multiple hardware form factors (especially important for Activision Blizzard, with console sales flat for five years), a total addressable market of every smartphone-owning person on the planet, and the ability to cost effectively launch new, female-oriented IP without having to rely exclusively on marketing.