What Will Save Zynga?

| About: Zynga (ZNGA)

Zynga (NASDAQ:ZNGA) is an enigma wrapped in a mystery. Once again, the stock price fell this week below the value of its assets on news that the company was laying off workers from OMGPOP as a cost-cutting measure.

Friday, the stock price closed at $2.84, compared with total long-term and short-term assets that suggest a value of $3.17 - an 11.6 percent discount. And, the company still has $1.4 billion in cash - or $1.79 per share. Over the past year, the company's core assets have declined 3 percent, falling from $2.605 billion to $2.523 billion, partly the result of a write-down on its buyout of OMGPOP.

During this same time period, the stock has plunged from $11.91 at the start of Q2 2012, a stunning 76 percent decline. Year-to-date, however, ZNGA is outperforming the market, higher by 20.3 percent. But, from where it closed 2012, ZNGA had little place to go but up.

Quick overview

With the price of ZNGA once again below core assets, I believe that ZNGA is a buy. If the market is disrupted by a shakeup in ZNGA management or a change in U.S. online gaming, there could be a sharp increase in the stock. However, because of the nature of the underlying news, using a firm risk/reward setup is best for capitalizing on an anticipated recouping of recent losses.

Recommendation: Buy the January 2014 $2.50-3.50 call spread for $0.39, a $0.05 premium over Friday's closing price, and an efficient way to go long the stock at these levels. Risk: $39 per contract; Potential profit: $61 per contract for a 156 percent potential return.

Management is a problem

Zynga's recent history is overshadowed by its main problem - Mark Pincus. The only reason Pincus has his job is that he controls 50.15 percent of the voting shares. ZNGA needs a shake-up, but Mark Pincus would have to voluntarily give up control of the company. Is that likely? Perhaps more than some people might imagine.

Zynga is not Pincus' first company - and not his baby; it's his fourth. He sold his first company after seven months, and took his second company, Support.com, public during the tech-fueled bonanza that was the late 1990s. Even his third company, Tribe.net, was sold to Cisco Systems four years after he began.

If Pincus brings in an outside help to reposition the company, it would definitely cause bears to scatter and send the stock price higher. Take Groupon for example. Since firing CEO Andrew Mason, Groupon (NASDAQ:GRPN) gained 30 percent - signs that the bears have more faith that the company will pivot to a new, more profitable focus.

Was this week a watershed moment?

ZNGA's massive layoffs and cost-cutting was a definitive statement. However, the 18 percent cut in workforce and savings of $70-80 million were not met with welcome arms among Zynga shareholders, who sold the stock off by 16 percent following the announcement. And, the price of the stock closed on its low for the week.

Yet, there could be reason for optimism. With Zynga closing down an additional four games in the second quarter, the company can shift resources to focus on mobile and real-money games, two areas with explosive growth prospects.

First, let's focus on real-money games. Zynga has the most popular free game poker here in the United States, with more than 36 million users on Facebook, and around 6 million users active on any given day. Critics may argue that this user base is insignificant because online gaming is illegal in the U.S., but that could be a narrow-minded focus. All that ZNGA would need is a whiff of movement in the Federal sphere before the stock price would soar.

In the U.K., Zynga is live with real-money gaming in a partnership with bwin.party. Though this is a congested marketplace, it will provide an important test for Zynga's platform.

Second, mobile. This is an unknown for ZNGA. Part of the reason for the sell-off in ZNGA since Tuesday's announcement is that it casts doubt on their mobile strategy. Mobile bookings in Zynga's Q1 rose 21 percent, following a 75 percent increase in 2012. Mobile currently accounts for roughly 25 percent of the company's active users, a number that will continue to grow.

Companies across the spectrum are just learning how to capitalize on mobile strategies, but social gaming has to be one area of explosive growth. By redirecting resources, Zynga is poised to take advantage.

What to monitor

Finally, here are five things to watch that could facilitate a sharp move higher:

  1. Change in management structure that shows Pincus is ceding some control. Pincus, who is currently CEO and Chairman, could start by splitting those roles - or bringing in a high-level executive - to help add new blood to the company.
  2. Government change in online gaming policy, even around the margins. Three states - Las Vegas, New Jersey and Delaware - currently allow online gambling and more are expected to join them. Charles Cohen, chief executive of a UK-based gaming maker, Probability Plc, has predicted that half the U.S. population will live in a city with legalized online gambling. Keep an eye on Congress and a potential Federal bill that could either support or derail this prediction.
  3. Zynga's mobile bookings, particularly relative to declines in the desktop. In last week's warning, Zynga also warned that bookings would come in below expectations. But, with a large emphasis on mobile, growth in that market is really all that matters.
  4. Real money gaming performance in the U.K. Zynga's partnership with bwin.party is going to be critical for Zynga moving forward - as a case study in a challenging market. How Zynga is penetrating that market will truly prove interesting.
  5. Zynga's Q2 earnings release and comments in July. Zynga is likely to get grilled on the conference call following its Q2 earnings release. How they answer these questions will be important in determining whether bears stop their assault on the stock.

Given Zynga's assets, which effectively put a floor underneath the price, and these potential catalysts, Zynga's recent sell-off could be an opportunity to buy.

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.

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