Is Zynga Attractively Priced?

Feb.21.14 | About: Zynga (ZNGA)

Zynga (NASDAQ:ZNGA) was probably the biggest player in online and social media gaming, and the status allowed the company to raise substantial cash through its IPO. However, since then, the stock has suffered heavily, and despite making a considerable recovery, it is still trading at almost half of the IPO value. The stock is up about 34% since the start of the year, and looks like the market is realizing the potential of the company and it will continue to go up over the next twelve months, in my opinion. When we talk about Zynga, the downside is limited and the upside is substantial. I will explain my rationale in the following paragraphs.

Limited Downside, Unlimited Upside

The market is still valuing Zynga with the negativity that has been attached to this stock in the past two years. At the moment, the valuation of the stock suggests that the company will never be able to come up with a product that can bring in cash - in other words, it can be said that the current value is close to the liquidation value. Whenever we value a business, we assume that the business will be in operation for the foreseeable future and the growth will at least be commensurate with the growth in the sector, at least for a well run business. If we apply the same logic to Zynga, the stock is worth a lot more than the current value. The growth rate in the gaming business is huge and it is clear from the performance of the company over the last two quarters that it has realized where the growth areas are. If a business is growing then it should be valued as a going concern, which is not happening with Zynga.

Let's now look at the limited downside - the company has substantial cash reserves and some very valuable properties. If we only take into account the cash and properties (I am taking the book value, market value can differ from the book value) of the company, we get per share value of close to $2.85. I have not included other assets in the valuation. So, it can be said that this valuation is the liquidation value of the company. If we compare it with the current valuation of the company; it represents a downside of around 40%. So, even if the company is liquidated, which I believe will not happen, the downside is only about 40% -- the stock has given almost the same return to investors in the last two months. If we include other assets in the valuation, the downside risk will further come down, hence my belief that Zynga has a lot of room to grow and it will be a very profitable investment.

Important Factors to Consider

Now that we have valued the stock based on its liquidation value, let's look at the future prospects and value the stock on going concern basis.

  • First of all, the most important thing to notice is the change of leadership. It is appreciable that Mark Pincus realized the issue and handed the reign to Don Mattrick. The old leadership had failed in targeting the growth areas and the top and bottom-line growth had become sluggish for the company. The new leadership is targeting the high-growth areas, which has resulted in increase in growth for Zynga.
  • The operations of the company are in order - the downsizing and the decision to rent some of its properties have resulted in decreased operating expenses, which has given support to the earnings of the company. However, it should be kept in mind that for the long-term sustained growth, revenues should increase at a growth rate higher than the earnings as expenses can only be decreased to a certain point. The sustained growth will always come from a company's ability to grow its revenues.
  • Zynga is making solid inroads in the mobile gaming segment, which is the fastest growing segment of the gaming industry at the moment. The continued growth in mobile should enhance the revenue as well as earnings growth of the company. As I mentioned above, the market is completely discounting the factor that a single hit game can lift a company, and the market is assuming Zynga will not be able to come up with another popular title. We only have to look at Candy Crush Saga, which helped King Digital Media bring in around $1.8 billion in revenues. Another example is the flappy bird, which had massive number of downloads. The mobile gaming market is extremely attractive and a single hit title can bring in massive cash flows. Zynga's approach to mobile gaming is one of the main reasons I am optimistic about the prospects of the company.

Conclusion

As I said above, the stock has limited downside and unlimited upside potential. I believe Zynga is more focused and better positioned to grow now. The new leadership has given the company a better direction to grow its revenues along with the efficient use of its resources. Zynga still remains one of the major players in the social media gaming and its ability to come up with new popular titles will be vital for the company over the next few quarters.

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.