Zynga (ZNGA) is one of the worst IPO performers in recent history, giving ~75% loss to its IPO investors. The biggest reason for this decline was the media hype and overvaluation during its IPO and company's growth slowdown. However, this overnight social media success has started to restructure and streamline operations as it seeks to recalibrate the company to the new reality. We think that the market has gone from an extreme overvaluation to extreme undervaluation, providing an attractive entry point for both value and growth investors.
- Research and Development - Zynga spent almost 50% of its revenues on R&D expenses in 2012. The company spent more than $700 million on developing new games. Despite recent personnel cutbacks, the vast majority of the company's employees are involved in developing and improving games. Zynga's R&D team has delivered world beating blockbuster games in the past. There is no reason to believe that they will not be able do so in the future. The market is currently not pricing in the possibility of another global hit game like Farmville, which could substantially increase the company's bottomline. Activision (ATVI) which is 6.5x time Zynga's value, spends the same amount in R&D.
- Leading Paradigm Change in Gaming - Zynga is the leader in the high growth industry of casual/mobile/social gaming. The company has leading titles such as Farmville and Mafia Wars, which are extremely popular with a large number of Internet users throughout the world. The casual gaming industry has not found a way to monetize the huge amount of time casual gamers spend on games in a significant way. Selling virtual articles and advertising are the two major ways of earning money through these games. Mainstream gaming companies like Electronic Arts (EA) and Activision rely mainly on selling titles to generate revenue. Zynga has grown its revenues by ~10x during the last two years, from $121 million in 2009 to $1140 million in 2011. While the company's sales have plateaued at ~$285 million in the last few quarters, the company's valuation has already factored in the slowing rate of topline growth.
- Massive User Base - We think that the market is not correctly valuing the huge user base that Zynga has, with over 300 million active users. This implies that Zynga is being valued at less than $7/user, which seems a bit too low in our view. This large user base represents one of the biggest assets for Zynga and was one of the main reasons for the over exuberance during the IPO. We think that the market has now gone from over exuberance to extreme pessimism.
- Restructuring and Cost Cutting - Zynga management seems to have realized that being a Social Media darling won't pay the rent. The company is sharply restructuring the organization and focusing on its core products. The company announced a 5% cut of its workforce, which will lead to $15-20 million in cost savings. We think the company's decision to shut down 11 games to reallocate resources to core areas was a good one.
- Real Online Gambling - The company is making a serious push into online gambling. The company has partnered with UK company bwin, to start online gaming in the UK. Zynga has also applied for a license in Nevada, to offer online gambling. Zynga has millions of users for its popular Zynga Poker. Moving even a fraction of these gamers to real online gaming could lead to a massive jump in company's revenues. Note that this venture is not expected to start anytime soon, as gambling approvals take time. We think that the online gaming option is not being priced in the current stock price.
- Huge Cash Hoard - Zynga has a huge cash hoard of ~$1.2 billion, which means that almost 60% of the company's stock price is accounted by cash alone. If you take out the cash, then Zynga looks even cheaper than its much below the industry average valuation. The market is giving an extremely low value for its existing operations and it is trading more like a company which is about to go bankrupt. The company is not bleeding money, as it turned a profit in the last quarter. As the company management reduces costs, margins and profits are going to improve even more.
- Share Buyback - The Company announced a $200 million buyback in October 2012, to return some of its massive cash hoard to investors. This is a good move in our view, as its signals that the management thinks that the stock price is undervalued. Also unlike some other beaten down companies, Zynga can easily afford this buyback.
- Acquisition Target - Zynga represents an attractive buyout target for other Internet and gaming companies, given its currently cheap valuation. The company could easily be bought by gaming companies like Activision, looking to make a move into the newer social gaming space. It could also be bought by opportunistic PE funds looking to make a fast buck.
- Synacor Partnership - Zynga has recently partnered with cloud TV service provider Synacor (SYNC) to provide its games directly to 24 million subscribers of Synacor. Zynga is trying to increase ways to provide its game through more channels and platforms. This partnership is a good move in that direction.
- Valuation - The Company trades at low valuation multiples with ttm P/S of 1.3x and P/B of 1.1x. This is substantially lower than the industry average at 5.6x and 3.3x respectively. The company has been rapidly reducing its R&D and SG&A expenses to improve its margins. The company has shown a profit for the first time in the last quarter and should manage to remain in black for 2013 as well. The company is generating substantial operating profits on top of its massive cash hoard.
- Facebook Umbilical Cord cut off - Zynga's exponential growth and huge success can be attributed greatly to Facebook (FB), where social gaming took off. Zynga was present at the right place at the right time, to take advantage of this paradigm change in gaming. The recent change in relations between Facebook and Zynga has been one of the biggest reasons for Zynga's stock price fall. Since Zynga gets most of its revenue from Facebook, one of the biggest risks is how Zynga will perform, once it loses its preferred access of the FB platform.
- Acquisitions at a High Price - Zynga wrote down more than 50% of the $180 million cost of acquiring mobile game developer OMGPOP. The company has more than a billion dollars in cash and there is always the risk that its management may squander the money in more such expensive acquisitions.
- Monetization Issues - The Company has not evolved the social gaming industry, after the initial success with Farmville and Mafia Wars. The company has not discovered additional ways to monetize its large user base. The company relies mostly on the "freemium" model by selling virtual objects to its users. The company has not fully utilized advertising to maximize revenues.
- Dependence on other Internet Platforms - Zynga sells most of its games on Google (GOOG), Facebook and Apple (AAPL) platforms and has to share revenue with these technology giants. The company realized this dependence and tried to develop its own platform under "Project X". However, we think for a small player to develop a global Internet platform is impossible.
Stock Price Performance
The company's stock price has acted like a roller coaster, with its stock price appreciating by almost 60%; to reach a peak of $15.91 in March 2012, after its IPO in Jan 2012. The company's stock has declined since then, to reach an all time low of $2.09 as a torrent of bad news poured in. The stock currently trades at $2.59, giving the company a market capitalization of roughly $2 billion. The company's performance in the last year has only been "worsted" by Groupon (GRPN), which has seen a 73% decline. Overvaluation in a time of IPO and growth slowdown has combined to make Zynga one of the worst technology performers. This has provided an attractive opportunity entry point for investors.
We think that Zynga is currently highly undervalued, with the market giving it a value of only $800 million (if you exclude its cash from the balance sheet). The market is pricing the company as if it will go bankrupt, without the possibility of it massive R&D team introducing new blockbuster game titles. The company's management has started to sharply cut costs and streamline operations. The company's strong push into online gambling provides another upside possibility. The risk reward proposition is very compelling in the case of Zynga. Given its current valuation, it also looks like an attractive buyout target by bigger Internet and gaming companies.