Zynga: Be Honest

Aug. 1.13 | About: Zynga (ZNGA)

Shares of volatile social games developer Zynga (NASDAQ:ZNGA) closed Wednesday back below $3 per share, with the euphoria over the hiring of a new CEO recently eclipsed by a disastrous second quarter earnings report and the company's decision to abandon real-money gambling in the United States.

Last week's report sent the stock down 14 percent; but, in reality, the drop seems like it should have been more severe. To begin with, the real-money gambling opportunity created a number of big upward moves for Zynga, including a 15 percent gain in April after the launch of RMG games in the UK and a 10 percent gain over two sessions in December after merely applying for a finding of suitability in Nevada.

Those gains were largely illusory and often short-lived -- as I pointed out in October, simply based on volume and market share, the UK partnership had essentially no chance of influencing Zynga's top or bottom lines. Still, one would think that the end of what so many touted as a "game-changer" for the company would, on its own, create a drop at least equal to the short-term boosts real-money optimism has created. Add in a horrific Q2, with revenue down 31 percent year-over-year and bookings down 38 percent year-over-year, and a more substantial haircut could easily have been envisioned.

There is, however, another way to look at it, one which shows just how severely the view of Zynga's operating business changed last week. Zynga, as its bulls are fond of pointing out, has $1.53 billion in cash and investments. As such, last Friday's move from $3.50 to $3.01 lopped off nearly $400 million in market capitalization; but dropped Zynga's enterprise value by nearly one-third. (Market cap calculated using diluted shares outstanding after Q2; enterprise value calculated as market capitalization less the sum of cash and investments.)

Yet the Zynga bulls remain out in force, talking up the company's cash balance, its "potential," and even arguing that the company's real-money ambitions are taking a "pause," or simply "a matter of timing." But valuation aside, even Zynga bulls must finally be honest -- at the very least with themselves -- about some of the key problems with this company.

You can't trust the management.

Former CEO Mark Pincus repeatedly touted the virtues of online gambling for his company, calling iGaming a "natural fit" in early 2012. "We're interested, but you should expect to see us do a lot more than what you've seen in offshore [online] casinos," he told a Morgan Stanley conference that February.

Yet in the wake of the hiring of new CEO Don Mattrick early last month, Forbes columnist Nathan Vardi called Pincus's running commentary a "bluff," presciently arguing that the hiring of Mattrick -- who has no online gambling experience whatsoever -- showed that Zynga "is a gaming company, not a gambling company."

Indeed, it has been sixteen months since Pincus argued that "you should expect to see us do a lot more," and the company has done... basically nothing. The partnership with bwin.party required hardly any technical expertise from Zynga's end. All Zynga would do is act as a "skin" for PartyPoker in the UK, with the front-end showing Zynga logos and the back end -- the essential part of the game -- running on bwin.party servers. Meanwhile, the oft-cited "Nevada license" application was not a license application at all, merely a finding of suitability ahead of a potential licensing process.

Put another way, Pincus said 16 months ago that his shareholders should "expect to see us do a lot more" toward online gambling. Over the time his company has spent over $600 million in research and development; yet the only movement in iGaming is an aborted start to the licensing process in a single state and the creation of a partnership where Zynga gets a minority share of what appears to be a roughly $30 million revenue market for bwin.party. One year later, at the same conference, Pincus again made big promises, aiming to bring RMG to the "mass market audience," comments that clearly showed his ignorance of the online poker market. He failed to mention that his promises from the year before had been left largely unfulfilled, as would his statements this time around. Less than six months later, Zynga quietly stepped away from RMG, its success in the space coming nowhere close to Pincus's grandiose predictions.

Beyond Pincus, Zynga has seen an almost laughable exodus of executives, with three more leaving this month. According to Bloomberg, six different social gaming companies -- now Zynga competitors -- have been formed by former Zynga executives. As GigaOM wrote last week, the average Zynga executive lasts about 16 months, raising doubts about the new CEO's potential tenure.

If Pincus -- still chairman of the company -- stays true to form and changes his mind within the next year or two, suffice it to say that Mattrick will still be well compensated for his time. Mattrick's three-year compensation from Zynga will top $50 million, at least $17 million per year. According to New York Times data on CEO pay, that figure would have put Mattrick's pay package in the top 75 or so of US CEOs last year. That is a stunning pay package considering that Zynga's business is worth barely $800 million and by year's end will no longer be a billion-dollar company in terms of revenue, either. Among the companies paying their CEO less than Zynga has promised Mattrick: giants such as ConocoPhillips (NYSE:COP), Raytheon (NYSE:RTN), Bristol-Myers Squibb (NYSE:BMY), and IBM (NYSE:IBM).

Of course, the excessive executive pay is nothing new; Zynga has never shown any concern for protecting its shareholders' cash. Over the last ten quarters, Zynga has doled out $938 million -- more than its current enterprise value -- in stock-based compensation to executives and directors. Insiders famously dumped half a billion dollars' worth of stock at $12 in March 2012, soon after the company's IPO, and soon before ZNGA collapsed into the single digits. Around the same time, the company spent another $210 million of shareholder cash on studio OMGPOP; the purchase appears to have taken place literally the day on which OMGPOP's Draw Something game peaked. The studio was shut down less than fifteen months later, and the entire investment written down.

So, yes, Zynga has $1.5 billion in cash, or nearly $2 per share. That's a good thing; the problem is that investors should have little faith that the company will do the right thing with that money.

Zynga is not a gambling player -- not now, not in the future.

On Twitter and in comments here on SA I've seen the argument made that the company is merely stepping back from real-money gambling to focus on social gaming, and that RMG progress is simply a matter of timing. Some analysts have argued that the move is, in fact, a good one -- and I agree.

But it's not because Zynga needs to focus on social gaming (it does); it's because Zynga is not a gambling company. I repeat: Zynga is not a gambling company. Yes, it has a partnership with bwin.party Digital Entertainment in the UK (OTCPK:PYGMF); but bwin.party is doing all the heavy lifting while Zynga essentially piggybacks on its existing infrastructure.

Last year, I laid out the detailed case for why Zynga would not succeed in iGaming; yet in this case, reading the pro-Zynga case may be more edifying. Here is SA contributor George Kesarios earlier this month on Zynga (though, I should point out that he has recanted his bull case for the stock):

See, entering the gambling business does not require much brains. You hire a bunch of smart people to develop the platform (Zynga has already done that), you wait for the Federal Government to give the OK, you bid for a license, you win the license, you pray there will not be much competition and you start printing money. It's as simple as that.

I don't mean to criticize Kesarios alone; indeed, the reason I quote his argument is that has been so widely disseminated over the past eighteen months. And yet, it is completely and totally wrong. First, the gambling business requires incredible brains; one look at the cutthroat nature of iGaming in Europe shows how nimble companies must be to manage competitive, regulatory, and economic pressures. Indeed, bwin.party, Zynga's UK partner, has lost nearly two-thirds of its market value since the merger of PartyGaming and bwin created that company. (It's worth noting that the fall came well after both companies left the US market in 2006; the company simply is struggling amidst a ruthless European market.)

Kesarios's second point is the most erroneous, and most widely repeated. He claims Zynga has already developed a platform for iGaming; they have not. Zynga Poker does not have a platform developed for real-money gambling. There is a reason they are using bwin.party's infrastructure in the UK. Zynga does not have geolocation or age verification software to satisfy US or European regulators. Its platform is vulnerable to hacking; its games are riddled with bugs, and the company has been called "creatively, and morally, bankrupt."

Again, it's worth repeating: Zynga does not have an iGaming platform ready to go live. As such, arguing that Zynga Poker is suitable for real-money gambling is like arguing that Microsoft (NASDAQ:MSFT) should compete for defense contracts since it develops the popular Flight Simulator game. Zynga could, potentially, develop the back-end capabilities necessary for real-money gambling, but it has not; again, sixteen months after Pincus warned investors and analysts to "expect to see us do a lot," nothing has been delivered.

The lack of a ready platform also means that no partnership is forthcoming, at least not with a bricks-and-mortar operator in the US. No operator will partner with Zynga if Zynga cannot take iGaming live under that operator's brand. And, again, Zynga cannot. And if it's no longer developing that capability, then there is no point for a US operator to partner with Zynga. None.

Meanwhile, the federal government is nowhere close to iGaming legalization, and "praying" for a lack of competition won't make it so. There are over 20 applicants in Nevada and 37 service provider applications in the more lucrative New Jersey market. Every one of those 37 has what Zynga does not: currently viable iGaming infrastructure. To quote Kesarios, "it's as simple as that."

The legacy business is collapsing.

Take a look at these figures:

ZNGA Fundamentals 2010-2013
Year Revenue (MM) Bookings (MM) Adj. EBITDA (M) Non-GAAP EPS
2010 $597.5 $838.9 $392.7 $0.38
2011 $1,140.1 $1,155.5 $303.3 $0.24
2012 $1,281.3 $1,147.6 $213.2 $0.07
2013 $734.11 $692.42 $34.63 ($0.07)1
Click to enlarge

1 -- consensus analyst estimate

2 -- author estimate based on first half results, Q3 guidance

3 -- based on high end of guided Adjusted EBITDA margin of 0-5%

data from Zynga press releases

Note that bookings are leading revenue down; meanwhile, quarterly bookings have gone from $230MM in Q1 to $188MM in Q2 to a guided range of $125-150MM in Q3. That is a 40 percent drop in six months. The effect on revenue over the next few quarters is likely to be drastic, and the hopes for a profitable 2013 for Zynga -- by any measure -- are plummeting along with sales. Adjusted EBITDA has fallen every single year, and could potentially turn negative in 2013.

Meanwhile, Zynga has now lost its social casino crown to Caesars Interactive (a division of Caesars Entertainment (NASDAQ:CZR)). Executives at Facebook (NASDAQ:FB) -- formerly Zynga's key partner -- spent their most recent conference call talking up the success of Zynga rival King.com, maker of the popular Candy Crush Saga game. The social media platform also unveiled its own mobile gaming initiative, which can only serve to drain Zynga's already shallow moat.

There is no reason for a Zynga takeover.

Zynga doesn't have best-in-breed software; it does not have an iGaming-ready platform. Its games have been criticized for largely copying those of smaller operators. Its top talent has defected -- or been pushed out -- at an astonishing rate. And there's little point to paying a premium for declining games when new games can be developed for a fraction of a cost.

And yet, that hasn't stopped "Hail Mary"-type hopes for a takeover by Microsoft, Facebook, Activision Blizzard (NASDAQ:ATVI), or anyone else. It's not going to happen. Zynga is already laying employees off by the hundreds and shutting down its games; if the company itself doesn't think its labor force and intellectual property have much value, why would an acquirer?

Zynga shareholders and potential investors must understand and accept these key points. Now, if a Zynga bull wants to argue for a turnaround play here; if they feel that Mattrick's experience at Electronic Arts (NASDAQ:EA) and Xbox Live can revitalize Zynga's struggling franchises; if they believe that the social gaming model still has value and that Zynga's tarnished, but still popular brand, can give consumers what they want, they are free to invest -- or argue for an investment -- in the stock.

But there needs to be a level of honesty towards the stock, and understanding of just what this company has done so far. Pincus promoted flowery visions of real-money gambling success that were neither feasible nor logical. He talked of his company's goal to "change the world" while they sold digital cows for pennies. Too many analysts and shareholders followed him down the primrose path. Anyone with or considering a long position in Zynga should be honest with themselves and remember the old adage: "Fool me once, shame on you. Fool me twice, shame on me."

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.