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On June 3, 2013 Zynga Inc. (ZNGA) announced a plan to cut costs through workforce reduction and closure of various office locations. According to the company's estimates, the plan would reap an annual savings of $70 million to $80 million, equivalent to around 5 percent of the company's total costs.

Effects of Cost Cutting on Margins

As per reported figures for the year ending December 31, 2012, ZNGA had an operating margin of around -14.28 percent. Based on the estimates of cost reductions, the new cost structure of the company would definitely improve the margin of the company to -8.57 percent, but this is still not enough for the company to enter into profitability. This is because the problem that ZNGA is facing right now is two faced, one is the issue of low and declining demand, and the second is sharp growth of its costs.

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As can be seen from the table above, ZNGA's early years were very profitable for the company, achieving double-digit growth in revenues; however, this growth substantially declined as more and more competition emerged, especially on the Facebook (FB) platform. ZNGA was heavily dependent on FB, and according to one estimate, as much as 80 percent of the company's revenues came from FB users. Thus, due to the severing of its close ties with FB, the company's revenue generation capacity was seriously affected. The state of the company's reduced dominance on FB can be estimated by the drop in the company's most popular game, FarmVille. At one time, the game grossed average monthly users in excess of 82 million, now as per most recent estimates, it can only manage just over 33 million monthly users. Although the company still possesses the top spot in games on FB, the competition has significantly intensified.

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As can be seen from the table above, that cost composition has been relatively stable over the periods. As expected, the largest cost category for the company is research and development, and the second largest category is the cost of revenues. Thus, the analysis of ZNGA's cost categories does not provide any insightful information, as there is no category in which excessive payments are comparable to other cost categories.

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The company has been successfully able to cut costs over the past four quarters, and this cost cutting is evident over all the cost categories. Although it is beneficial for the company to reduce costs in all the categories, a cost cut in research and development might make company's long-term sustainability difficult. However, the primary reason for cost cuts has been through the reduction of stock-based compensations, thus it may not have a significant adverse effect on the company's long-term prospects.

ZNGA's Financial Position

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The company has persistently reported strong balance sheet figures over the periods. Its financial liquidity position as well as its solvency position has remained strong. The company's current ratio has remained over 2 throughout the periods stated, and was recorded at 3.30x in Q1 2013. Similarly, its debt-to-equity has also remained significantly low and was recorded at 0.1 in Q1 2013.

The stock is currently trading at $2.71 as of June 6, 2013, and as per the Q1 2013 results, the company currently has approximately $2.1 in cash and marketable securities per share. Thus, essentially an investor in ZNGA pays only $0.61 per share for future growth opportunities. ZNGA's cash flow position has also significantly improved over the periods, with more than $67 million generated from operations in Q1 2013, as compared to $26.4 million in Q2 2012. This is a growth of more than 53% in a single year.

The high cash flow generation and large sums invested in liquid assets puts ZNGA at a unique advantage, as it can easily use these cash balances to gain growth from external sources through acquisition of high-potential startup companies. The high cash balances are also beneficial for the company, as it enables them to invest much more heavily in R&D, making its long-term prospects very bright.

Conclusion

In my opinion, ZNGA's main market has great potential to expand in the future; however, this growth will also bring in a lot of competition. The company, realizing the threat of intense competition, has already started expanding onto other platforms, such as smartphones. These initiatives would definitely bring in high revenues for the company, as it becomes less dependent on FB and as the smartphone industry expands rapidly. Further, the company should also focus more on other revenue-generating sources, such as advertisement. The promotion of its Zynga.com platform would highly improve the company's ability to generate revenues in the future, both through advertisements and the sale of virtual goods. Another important dynamic to the company's growth potential is the ability of the company's management to prudently use its cash in order to generate synthetic growth through acquisitions.

Thus, I believe that the company will continue to see poor performance in the near term; however, it eventually will be able to turn the tide. Based on my analysis, I would recommend a long-term buy for the company.

Source: Is Zynga Still A Long-Term Buy?