A Sip Of The Zynga Kool-Aid

| About: Zynga (ZNGA)

Online social game developer Zynga (NASDAQ:ZNGA) surprised investors with a penny profit per share in the March 2013 quarter. For those who are not closely familiar with Zynga's financial performance, since the company went public in 2008, it has delivered annual net losses in all but one year. Such profit news usually triggered celebration in the investment community and floated public company shares to record levels.

Unfortunately, that penny was not enough to smooth brows furrowed over Zynga's weakening sales and mushrooming competition for the consumer 'mindshare' not to mention consumers wallets. Indeed revenue in the March 2013 quarter declined 18% compared with the same quarter last year - a steep decline in fortunes for a company that had experienced meteoric increases in previous years.

In the weeks since the first quarter 2013 earnings report discussion has focused on the company's various tactics to set things straight. To cut costs offices around the world have been closed and the workforce is being reduced by 5%. Zynga's flagship game called "Farmville" is being ported to mobile devices so that game participants can enjoy a seamless experience from computer to smartphone. As many as 20 other game titles have been mothballed. Most importantly Zynga is embracing online gaming to drive future growth.

It all sounds so very interesting and the deeply depressed stock price makes for an enticing entry point into a 'modern gaming business.' Do I dare take a sip of the Zynga Kool-Aid?

For companies like Zynga that make great promises but have yet to deliver consistent profits, it is worthwhile to step back from all the hype about markets and products and demand to look carefully at the company's balance sheet.

The first thing that stands out on Zynga's balance sheet is cash. Cash and short-term investments totaled $1.3 billion at the end of March 2013, representing 50.3% of total assets. Another $402.7 million in long-term financial assets could be loosened up in a pinch. Indeed, financial assets represent 66.3% of total assets.

Zynga is awash with cash. In the last five years Zynga generated $1.1 billion in cash from operations. That represents an average sales-to-cash conversion rate of 35.3% during those five years. It is an impressive achievement for a company with so many years of deep losses.

It is illuminating to explore what is driving operating cash flow. Zynga paid total of $882.2 million in stock compensation paid in the last two years. Compare that amount with $613.8 million in pre-tax loss in those two years. So it seems management's zeal to stuff employee portfolios with company options is one of the reasons Zynga is reporting net losses. Of course, depressed income is only the first leg of stock compensation. Later, if the stock price increases enough to trigger employee option exercises, shareholders can revel in the dilution from higher shares outstanding. That is a story for another day.

Today we are focused on the balance sheet, more specifically all that cash on the balance sheet. Using the rule of thumb that a company needs cash to support operations equal to about 20% of sales, it seems Zynga needs to keep about $245.0 million in the bank. That suggests the rest of Zynga's cash and short-term investments - about $870.5 million - is languishing on the balance sheet earning a pittance in interest payments. Zynga management has invested in new products, particularly the online gaming initiative. Research and development expense totaled $2.1 million during the last five years. Even with this commitment of resources the cash has piled up in Zynga's bank account.

If there is no business investment opportunity, many would argue that shareholders should be the recipients of the abundance. Zynga announced a $200 million share buyback in October 2012. Management got busy right away, snapping up about 5.1 million shares at an average price of $2.36 per share and using about $11.8 million in cash before the end of 2012. Their enthusiasm for the task seemed to wane in the first quarter 2013. The company bought only 1.0 million shares at about $2.40 per share for a total spend of $2.4 million.

At the end of March 2013, Zynga had about $185.8 million left over from the board's authorization that could still come the way of shareholders. At the current share price near $3.50 per share that means about 53.0 million shares. As enthusiastic as investors are toward ZNGA - bulls and bears alike - that many shares represent only about two days' worth of trading volume.

Discussion of Zynga's product portfolio, the migration to mobile devices and online gaming will likely occupy the chat room conversations. However, in my view the real story for Zynga is how management is handling other financial questions. How much cash is enough cash for operations and investments? Is there a point where the drag on near-term earnings and future dilution are so onerous that stock-based compensation is overdone? Is shareholder return important enough to follow through on promises to put money in their pockets buying back stock?

If you think management will respond to these questions with the same answers you would give as a shareholder, then drink up the ZNGA Kool-Aid. Hey, make it a double shot.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.