Beware This Sweet Gaming IPO

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

King, the maker of Candy Crush Saga, is reportedly eyeing an initial public offering. While this single game is hot today, Zynga's (NASDAQ: ZNGA) fall from grace should be ample warning to investors. Most would be better off sticking to giant video game maker Electronic Arts (NASDAQ: EA).

Casual Games

While it may be hard to believe today, there was once no such thing as a casual video game. Sure, games like Sim City and Tetris captivated a wide audience, but that demand was still focused on computer users at a time when computers weren't mainstream. Other games, meanwhile, were mostly geared towards kids.

The start of the casual market really came about with Nintendo's (NASDAQOTH: NTDOY.PK) Wii game console. That game machine's motion-sensing controller radically altered the game experience. With a focus on family-friendly fare, sales at Nintendo rocketed from $500 million in 2003 to $1.8 billion in 2008.

That's been the high water mark, however, as sales have fallen every year since then and are now about a third of that peak. Making matters worse, the company brought out an updated version, Wii U, and sales have continued to fall. Clearly, the company lost its mojo in the game market.

With Sony and Microsoft slated to bring out new game consoles at the end of the year, investors should avoid Nintendo.

Hardcore vs Casual

Hardcore gamers tend to be very loyal to both game systems and games. These players will spend huge sums on the best equipment (like an Xbox or PlayStation), spend hours building up their skill at a game, and then happily buy additional installments of a game to continue the experience. Casual game players aren't asked to invest as much in simple, often free, casual games and thus move on to the next big thing as soon as they get board.

That's been the experience of Zynga. The company came public amid huge expectations that it would dominate the casual game market by giving away free games and charging customers for in-game purchases. However, there were big problems with the company's model from the start.

A Social Issue

For example, it relied almost exclusively on Facebook for customers. While Zynga has broadened out, it hasn't been able to find a ready customer base to offset its reliance on the most-used social network. That's a huge business risk, particularly since the social network model is relatively new and still changing rapidly.

Second, there are few barriers to entry in the casual game market. Facebook has no loyalty to Zynga, it's happy to collect revenues from anyone who makes a popular game. And, since there's no switching costs, customers have very little loyalty either. If Nintendo can't keep customers who have paid hundreds of dollars for a game console, Zynga shouldn't have expected to be able to keep customers who paid nothing.

Zynga is losing money, restructuring its business, closing facilities, and just hired a new CEO. After quickly running up more than 40% after the IPO, shares are now trading around 80% below their $14 high reached in early 2012. Investors should avoid the stock, but keep the lesson in mind as King moves toward its own IPO, backed primarily by the brand recognition of a currently hot game.

Better Option

Instead of following the next hot game into a risky IPO, investors should take a look at Electronic Arts. The company has struggled of late, with sales declining year-over-year in each of the last four quarters. Still, it has a solid lineup of games and has been strategically pushing into the casual game market.

In an attempt to position itself for the future, EA bought casual game makers PopCap and Playfish. It's used that platform to produce games like The Simpsons: Tapped Out, but has also started to expand its powerful game portfolio into the casual space. Need for Speed and FIFA are examples of games that have both been ported to the casual space in an attempt to reach new audiences.

With the PlayStation 4 and Xbox One set for a holiday release, EA is likely to see a sales boost as gamers buy into the new systems. The reach into the casual space may help broaden the appeal of its hardcore games, as less serious gamers recognize its brands. That's particularly true since both Sony and Microsoft are trying to make their game consoles entertainment hubs for the living room, where more casual gamers reside.

Although EA shares are well off of their highs, investors will need to act quickly. Shares will probably have already advanced strongly once the new game cycle starts later in the year.

Avoid the Hype

King's hot game may be a blast to play, but that doesn't mean its business model will be any more successful than Zynga's. Investors should avoid the hot IPO hype and stick to EA, a company with a long and largely successful history in the game industry, including a push into the casual game space.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Nintendo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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