I've Changed My Mind: Zynga Lives

Feb. 4.14 | About: Zynga (ZNGA)

I have to admit that I was dubious about this stock. With bloated R&D and SG&A costs, as well as terrible revenue from its R&D budget, Zynga (NASDAQ:ZNGA) looked destined to burn through its billion bucks of cash.

But, from last Thursday's announcement of the company's purchase of NaturalMotion, a 15% reduction in personnel, and a sense that the two new guys at the helm of this leaky cash cow, CEO Don Mattrick and Clive Downie, may actually pull this turnabout off to regain profitably, the landscape change gives me pause.

Radical Mind Change

I've changed my mind about Zynga. I now sense that the company could actually be wildly profitable in 2015, with the real potential of regaining $1 billion of revenue by 2015 with NaturalMotion's cutting-edge technology and the proven success of the recently-acquired company's talent who produced such popular games as Grand Theft Auto 5, Lord of the Rings, Clumsy Ninja and My Horse.

Salvos launched by some journalists that Zynga paid too much ($527 million) for NaturalMotion don't understand the reality of the delicate marketplace of entertainment. Either Zynga's got the talent on its payroll, or it doesn't. It's not a matter of throwing money at the product through headcounts.

Anyone "can come in from left field" and produce a $1 billion hit without spending tons on R&D, NaturalMotion board member Mitch Lasky told the Wall Street Journal. Zynga's move to acquire NaturalMotion's small pool of proven wiz-bangs buys many more lottery tickets to a few-hundred-million-dollar, or possibly, a billion-dollar game.

"NaturalMotion's technology and tools pipeline are unmatched and represent a significant leap ahead in our ability to deliver next generation entertainment," VentureBeat reported Mattrick said in a conference call to investors. "We believe their cutting edge technology - called 'Euphoria' - will light up the future of our industry on mobile."

Wedbush Securities analyst Michael Pachter, agrees. Pachter told Bloomberg News, "Mattrick is saying and doing all the right things," adding, that the purchase of NaturalMotion will "beef up" Zynga's presence in a the mobile and tablet marketplace - a marketplace estimated to reach $13.2 billion of revenue this year, according to digital marketing firm Gartner Inc.

With Zynga's "Ville" games, virtual gambling and puzzle games added to NaturalMotion's "CSR Racing" and "Clumsy Ninja," Zynga will now have five of the top 50 games played worldwide, with more in the pipeline from NaturalMotion, such as a sequel to the Clumsy Ninja.

The "Euphoria" technology brought out in the Clumsy Ninja character "is one of the most delightful things I've ever seen," 20-year games veteran and Zynga's newly-hired COO, Clive Downie, said in a conference call, according to VentureBeat.

Investors may not want to underestimate the potential of NaturalMotion and the judgment of Clive Downie.

Back-of-the-Napkin Earnings Projection

As depressing as a drop to 112 million users at the close of 2013 (from 311 million in 2012) is to Zynga's top and bottom line, it appears that the company has bottomed.

Mattrick told investors on the conference call that 75% of Zynga's new games will debut on mobile first, tapping into that $13.2 billion annual revenue from the up-till-now unexplored mobile market for Zynga.

The company also appears to be executing the obvious by cutting a bloated R&D and SGA payroll by an additional 314 employees, according to the company's Thursday news release. That's on top of slashing 520 jobs last year. Therefore, it should come as no surprise that Mattrick announces further layoffs in coming months as the bang for the R&D buck coming out of NaturalMotion dwarfs Zynga's dismal R&D returns.

So, expect further announcements of personnel cuts, in my opinion. The structure of Zynga needs "streamlining," said Mattrick. And I know where he's going to streamline, the approximately $320 million doled out for R&D and $220 million squandered in SG&A.

Together, those two budget items represent 67.2% of revenue, and eat up all gross profit, according to Zynga's third quarter ending Sept. 30. We'll see what progress has been made to the financials when the fourth quarter is posted.

Back in fiscal 2010, when Zynga made a profit, a combined R&D and SG&A budget totaled slightly less than 50% of revenue, a goal I suspect Mattrick will achieve through a confluence of higher revenue and an appropriate level of operating expenses he's promised us.

Putting these assumptions to a spreadsheet, I calculate, at $1 billion of revenue, Zynga would need to bring back 111 million gamers from the 199 million lost (56%) during the past 18 to 24 months.

At $1 billion of revenue, operating costs must break 50%, say, back to the fiscal 2010 level of 49%. Gross margin appears steady at the 26% to 29% range since the company went public in 2011, so that's one less variable to wonder about. And the company has no debt.

As an example of how investors can justify today's $4.40 share price as a good buy, Zynga would need to return to fiscal 2012 revenue of $1.28 billion, and further reduce the combined R&D and SG&A costs back to the 50% of revenue level (which NaturalMotion makes possible). Under that scenario, full-year net income could reach as much as $330 million after taxes.

With 818 million common shares outstanding, $330 million calculates to annual earnings of 38.2 cents per share. Assuming a 15-times P/E, ZNGA could reach a minimum of $5.73 per share by 2015. If the company can achieve anything close to these targets by 2015, it's unlikely investors will assess only a 15-times earning multiple. At 25-times earnings, ZNGA approaches $10, at 30-times, $11.50, et cetera.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ZNGA over 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.