Earlier this year, I dove into the pile of cash held by on-line gaming provider Zynga, Inc. (ZNGA). It was a virtual experience, but exhilarating nonetheless, to be covered by $1.7 billion in cash and marketable securities that Zynga held at the end of March 2013. For a company with only $1.0 billion in annual turnover, the availability of such a large amount of cash led to some provocative questions concerning capital resource management by Zynga's leadership. There have been some developments at Zynga in the last half of the year, so I decided to revisit the questions I had posed for management in the May 2013 article.
How much cash reserve is needed to support operations? Investment for growth?
What is the right fit for employee stock compensation?
Will the stock buyback plan set in motion in late 2012 be carried out? Increased?
First, let's take a look at the balance sheet. All data in this article is sourced from Zynga's 2012 annual report, and the first, second and third quarter financial reports, all of which are available at SEC.gov. By the end of September 2013, Zynga had $1.1 billion in cash and marketable securities on its balance sheet - a significant reduction in cash since the beginning of the year. Where did the cash go?
Operations actually generated $20.9 million in cash in the first nine months of 2013. However, since we know the company had generated $26.4 million in the first quarter, we are tipped off that, as the year went along, operations began requiring cash support and actually used $6.5 million in cash during the June and September quarters. This is a relatively nominal sum, all things considered.
No red flags are waving, but there has been a notable development in Zynga's cash flow picture. Stock based compensation declined to $65.1 million in the first nine months of 2013, compared to $108.0 million in the same period in the prior year. Make no mistake about it, the powers that be at Zynga are not abandoning company stock for employee compensation. Zynga's new chief executive officer Dan Mattrick agreed to come on board mid-year, expecting to receive a bit more than $19 million in cash and stock during his first year on the job. He got $5 million in cash as a welcome gift just for showing up the first day. Then he is to receive a $1 million annual salary and guaranteed cash bonus of up to $2 million.
Mattrick is to receive $11.3 million in Zynga stock to make up for shares he would have received from this old employer, Microsoft (MSFT). There is more! Besides a cash signing bonus, Mattrick also received 1.8 million restricted stock units and an option to buy up to 7.4 million additional shares of Zynga stock. The former was an upfront grant while the later vests over a period of Total estimated value for Mattrick: $10 million. There appears to be considerable incentive for Mattrick to pump up Zynga's stock price - a circumstance that should please everyone but short-sellers.
One could make the argument that it is a smart move to align Dan Mattrick's personal incentives with those of shareholders. Another smart move is using $100 million in cash to pay down debt in the September 2013 quarter. The debt-to-equity ratio is now zero. That said, what would probably improve the overall assessment of Zynga's capitalization profile is not related to debt. Indeed, investors are probably more concerned about the accumulated deficit of $913 million - a deficit that keeps growing instead of getting smaller.
Hiring a new CEO was not the only personnel change made at Zynga in the last six months. As part of a restructuring plan formally adopted by the directors in June 2013, Zynga reduced its workforce by 520 people and closed some of its offices. In the September 2013 quarter, the company dished out cash totaling $22.8 million for employee severance and another $1.6 million related to the cancellation of contracts that really were non-cancellable. Another $1.1 million in non-cash charges brought the complete restructuring charge to $25.5 million.
It is probably too early to tell whether the work force reduction will have a meaningful impact on growth and profitability. I estimate the number of employees at year-end will be 2,400 to 2,500. Since Zynga is a relatively young company, force reduction is likely to have a different impact on operations than say a company that has been in business for decades. Before the restricting decision, over a third of employees had been with the company less than one year, and a whopping 70% had been drawing a Zynga paycheck for less than two years. If we assume that Zynga management favored those with seniority, we expect that most of the employees who remain are those with a longer work history with the company. This is potentially a tighter knit group with the ability to work together harmoniously to solve the company's problems. Most likely we will see a cost savings impact beginning even as early as the fourth quarter 2013, but the verdict is still not in on future growth.
One thing we do know is that the force reduction eliminates $14.3 million in future stock based compensation commitments. The hiring of a new CEO resulted in the commitment to issue another $21.3 million in stock and options. However, by cutting ties to a few hundred other, nameless employees, Zynga clawed back options with an estimated value of $14.3 million. With new stock and option issuance valued at $11 million, it is clear the leadership of Zynga has not fallen out of love with stock-based compensation.
The dilutive impact of new stock and option issuance underscores the importance of Zynga's stock repurchase program. In October 2012, the board of directors authorized the use of $200 million in cash to buy back stock. One year later, the company still had $178.9 million remaining under the plan. The company has repurchased 3.4 million shares this year at an average price of $2.74. This represents only 14% of average daily trading volume in ZNGA shares.
It is also interesting to note that most of the repurchase activity has occurred in the September 2013 quarter after the stock price had recovered from its low of $2.31 at the beginning of the year. Back then when the price was at its most depressed level, the company used just $2.4 million to buy back shares. The company appears to have been out of the market for its stock in the second quarter and then waited until the September quarter after the stock has recovered to deploy another $6.9 million for the majority of its repurchase activity in this year.
SHARE REPURCHASE ACTIVITY
Series A Shares Out
To be fair, in 2011 under a previous repurchase program, the company bought back 27.5 million shares valued at $283.8 million. The average price under that program was $10.32. Comparing the two programs and the trend in the stock price, it is a bit surprising that management has deployed the second repurchase authorization so sparingly. In my view, the axiom 'buy low and sell high' applies to company repurchases as well as the rest of us.
Six months ago, I had suggested that despite Zynga's problems, the low stock price was so compelling it could be a 'buy.' My 'one legged' bull case turned on confidence in management to make astute decisions about investment of cash resources. This six-month check suggests, the right intentions are there, but execution still leaves a bit to be desired. In my view, going forward, anyone who is prepared to retain or build a long position in ZNGA should continue to look at carefully at how the company is using its capital resources. The rising short interest is another interesting development. The announcement of a strong fundamental development could provide ZNGA holders with a very sweet 'short squeeze' effect.
Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.