Valuation: Why Zynga's Stock Is Worth Less Than $2

Aug. 2.14 | About: Zynga (ZNGA)

Summary

Zynga's hopes are pinned on its acquisition of NaturalMotion and CEO Don Mattrick's most recent management shakeup.

NaturalMotion may not be of much help and Mattrick's changes may be too little too late.

Even with some optimistic assumptions, Zynga's value is $1.6 billion vs. its $2.6 billion market cap or $1.80/share.

Zynga, Inc. (NASDAQ:ZNGA) went public in December, 2011. Its only profitable year was 2010. Sales peaked in 2012 at $1.28 billion and have declined steadily since then. As of the end of 2013, Zynga had lost 63% of its players.

To lift its sagging sales, Zynga announced the acquisition of UK-based NaturalMotion Games Ltd. in January, 2014. Although the news gave its stock a boost, it is not certain how much NaturalMotion will help Zynga.

On July 8, 2013, Pincus stepped aside as CEO and Don Mattrick of Microsoft replaced him. During the past year, Mattrick has shaken up management and reduced headcount, but Zynga's headcount and operating costs remain high. Even if he can increase Zynga's adjusted operating margin to 13% from -12% for the trailing 12 months [TTM], boost its sales-to-capital ratio from 0.64 to 1.3 and reverse its sales decline, it still doesn't justify the current stock price. This article explains why fair value is $1.80, 61.8% below the closing price on July 31, 2014.

Business Model

Zynga develops, markets and operates social games on the internet, social media and mobile devices. It generates revenue from ads, in-game sales of virtual goods and mobile download fees. Under Pincus's leadership, Zynga's strategy was to buy it or copy it.

Since 2009, Zynga bought some 24 firms for their talent, technology and/or entrée into foreign markets. Twenty of them are tabulated below. Most were small with no top-earning games and became satellite offices. Its best acquisition was probably MyMiniLife, from which it obtained the game, FarmVille, the inspiration for many subsequent titles, including its current top-grossing mobile game FarmVille 2.

List of Some of Zynga's Acquisitions

Firm Acquired

Date Acquired

Price Paid

Franchise

MyMiniLife

August 7, 2009

Undisclosed

FarmVille

Serious Business

February 11, 2010

Undisclosed

Friends for Sale

XPD Media (Chinese)

May 20, 2010

Undisclosed

Entrée to China

Challenge Games

June 3, 2010

Undisclosed

Warstorm, Ponzi

Unoh Games (Japanese)

August 5, 2010

$11.6 million

Entrée to Japan

Conduit Labs

August 17, 2010

Undisclosed

None-music-oriented games

Dextrose (German)

September 24, 2010

Undisclosed

None-game engine developer

Bonfire Studios

October 5, 2010

Undisclosed

None

Newtoy, Inc.

December 2, 2010

$53.3 million

Words with Friends

Flock

January 5, 2011

Undisclosed

Social browser

Area/Code

January 21, 2011

Undisclosed

Drop7

Floodgate Entertainment

March 18, 2011

Undisclosed

Mobile experience

MarketZero

April 5, 2011

Undisclosed

Poker Table Ratings

Wonderland Software (NASDAQ:UK)

April 27, 2011

Undisclosed

GodFinger-UK-based mobile game developer

OMGPOP

March 21, 2012

$200 million

Draw Something

Wild Needle

May 14, 2012

$3.8 million

Mobile games for women

Buzz Monkey

June 4, 2012

Undisclosed

Contract game developer

November Software

November 9, 2012

Undisclosed

Mid-core gaming

Spooky Cool Labs

June 19, 2013

Undisclosed

Real money gaming

NaturalMotion Games Ltd. (UK)

January 30, 2014

$527 million

CSR Classics-mobile game and animation engine developer

Click to enlarge

Sources: VBNews, TechCrunch, InsideSocialGames, AllThingsD, Boston.com, Mashable, Forbes, Games.com, WallStCheatSheet, gamesindustry Int'l.

Despite bulking up on talent and technology, Zynga's offerings have not been very innovative. In fact, Pincus has allegedly said he doesn't want innovation. Although the tech industry is known for copying others' products, Zynga has a singular reputation for copying competitors' popular games.

Business Condition

Zynga's sales have largely been fueled by its prior year acquisitions as shown in the graph below. Unfortunately, the positive impact on its sales has been short-lived. The company has demonstrated little ability to effectively assimilate its many acquisitions as shown by its consistent inability to sustain its acquisition-related sales growth for more than a year.

It is not known whether Zynga's inability to maintain sales growth stems from its acquiring weak companies and/or its legend work environment driving away talent.

Click to enlarge

Sources: SEC, VBNews, TechCrunch, InsideSocialGames, AllThingsD, Boston.com, Mashable, Forbes, Games.com, WallStCheatSheet, gamesindustry Int'l.

Zynga's acquisitions have had a lasting negative effect on its operating margin by bloating its headcount and its R&D expenses as a percentage of sales. In 2011, Zynga had 3,500 employees. As of Q1 2014, its headcount was 1,991. By comparison, King Digital Entertainment PLC (BATS:KING) with 3 times fewer employees produced 3 times more TTM sales.

Sources: SEC, VBNews, TechCrunch, InsideSocialGames, AllThingsD, Boston.com, Mashable, Forbes, Games.com, WallStCheatSheet, gamesindustry Int'l.

Moreover, Zynga's sales-to-capital ratio has fallen from a high of 2.0 in 2012 to 0.64 for the TTM ended March 31, 2014.

Zynga does have strengths, but we believe that they are outweighed by its weaknesses. Both are discussed below.

Strengths

1. One of Zynga's core franchises is its "Ville" series.

  • This franchise includes CastleVille, ChefVille, CityVille, CoasterVille and FarmVille. FarmVille and Farmville 2 were 44% of Q1 2014 sales.
  • Its recently released mobile game Farmville 2: Country Escape is currently the #13 grossing mobile game in the U.S on Google Play. It broke into the top 20 on the ninth day following its release and it may become a hit.

2. Gambling games are a core genre.

  • Despite being 7 years old, Zynga Poker is Zynga's second-best earning game accounting for 24% of sales in Q1 2014.
  • The mobile version was released some 3 years ago and still ranks #45 on Google Play in the US.

3. The new CEO has shaken things up.

  • After firing 3 C-level executives and changing assignments for the key game franchises last August, Mattrick completely revamped his senior management team this June. Gone are the former heads of mobile and acquisitions. Steve Chiang former head of the Ville series and Zynga studios also left. Mattrick hired Microsoft's Alex Garden to replace Chiang as head of Zynga studios.
  • Don Mattrick has reduced headcount and closed some satellite offices since coming on board last July.
  • The personnel changes are seen as key to transitioning Zynga to mobile.
  • Zynga's margins should improve once all the restructuring costs are absorbed.
  • Pincus finally stepped down as Chief Product Officer in April, 2014 which should improve Zynga's work culture.

Weaknesses

1. The company has only grown sales by acquisitions.

  • As the graph above showed, Zynga's sales have grown in line with the number of firms acquired the previous year. Absent acquisitions, Zynga's sales have fallen.
  • Unfortunately, some important future acquisitions may not be available to the company. For example in 2011, PopCap sold out to Electronic Arts for 20% less because it did not want to be bought by Zynga. Rovio also shunned Zynga.

2. The company has a history of failed acquisitions.

  • Zynga has consistently failed to generate sustained sales growth and profits from its acquisitions.
  • Like NaturalMotion, many acquired companies had little success marketing their own games and expected Zynga to provide this expertise. Very few of these firms contributed games of lasting value.

3. Pincus is still Chairman of the Board.

  • Although Pincus may be less involved with Zynga's day-to-day activities, he still controls 62.2% of the voting stock.
  • He is still in a position to block any changes he doesn't like and adversely affect innovation.

4. Zynga is still very dependent on Facebook.

  • 59% of Zynga's Q1 2014 revenue came from Facebook, Inc. (NASDAQ:FB). While down from 75% in 2013, the decline was due to falling Facebook revenues, not growing mobile sales.
  • Beginning March 31, 2013, Zynga became subject to various limitations on promoting its games on Facebook. It can no longer cross-promote games on other platforms on Facebook and it cannot use email addresses obtained from Facebook to promote any desktop games that are not on Facebook.

5. Zynga may not be able to innovate anymore.

  • Pincus discouraged innovation in favor of tried and true models like Farmville and Zynga Poker and copying others' successful games.
  • Zynga has lost a lot of talent since its IPO.

6. Zynga's mobile games are second-rate.

  • Despite acquiring many talented people, Zynga has developed few big mobile titles.
  • Although farm games are a key genre for Zynga, Supercell's Hay Day, ranked #5 on Google Play, remains the top-grossing mobile farm game vs. Zynga's thirteenth place FarmVille 2.
  • Zynga's Hit it Rich! Free Casino Slots is ranked #35. Playtika's Slotomania - FREE Slots Games is ranked #8.

7. Zynga may not be able to make it on mobile

  • Making it on mobile is non-trivial. Size alone is no guarantee of success.
  • Explaining why he decided to sell out instead of trying to overtake Zynga, Torsten Reil, founder of NaturalMotion said in an interview with The Guardian:

While it's true that the revenues possible with a hit on mobile are pretty incredible, even though small companies can achieve that, the expertise that's required to create a hit is pretty deep now. On the one hand, it's quite technical in terms of the creativity required.

But it's also quite technical in the insight you need to have on how to structure those games, how to retain players over time and make sure monetisation works. That expertise is non-trivial: the trend over the last 12 months has been that it's harder for an inexperienced small team to achieve that.

  • Supercell and King dominate mobile and they have a big lead.

8. Zynga's many acquisitions have bloated its payroll.

  • Zynga has the highest R&D expenses in its industry-49% of sales vs. King's 6%, even after cutting over 1500 jobs.

9. Mattrick's first round of changes weren't effective.

  • Sales continue to fall. Sales for the twelve months ending 3/31/14 were down 36.5% vs. the twelve months ending 3/31/13. Mattrick was present for 9 of those 12 months.
  • The operating margin for the most recent TTM was -15.5% vs. -0.6% for the TTM ending 3/31/13.

Opportunities and Challenges

Zynga's new management team is its best chance to transition from Facebook to mobile, but it will be difficult. King and Supercell are formidable mobile competitors.

While NaturalMotion's story of being founded by Reil who decided to use his biology doctorate to develop software to realistically animate 3D movement sounds like a winning new direction for Zynga, NaturalMotion's own games based on this technology may be already losing their resonance with players.

In an interview with The Guardian, Mattrick said:

"Their products have a tremendous wow factor. CSR and Clumsy Ninja have set a high bar in terms of production values, and they've learned that once you give people something delightful, they engage with it."

But, Clumsy Ninja was a flop on Google Play. It peaked at #87 for US grossing games 10 days after its April 7, 2014 launch. It performed better on Apple's devices, hanging on for a day in 12th and 27th places on the iPad and iPhone, respectively, before declining.

Click to enlarge

The car racing games, CSR Racing and CSR Classics were far more successful. CSR Racing enjoyed 6 weeks in the top 10 Android games after its release in April, 2013. It is currently #44 on Google Play and #62 in the Apple App store. CSR Classics which was released about a year later (March 24, 2014) was not as successful. It peaked at #16 for one day. It is now ranked #70 on Google Play and #75 on Apple.

NaturalMotion's technology is interesting and Reil's emphasis on making quality games is refreshing. Zynga needs higher quality games to compete. But, it is not certain that Reil will stay long or if he does, how much influence he will have on Zynga's culture.

Intrinsic Valuation

Growth Drivers

For this valuation, there are 3 ways Zynga can increase its value: increase sales, improve its adjusted operating margin and/or increase its sales-to-capital ratio. The starting values are: $873.3 million, -8.22% and 0.64, respectively.

  • Sales Growth

The company's sales growth history is as follows:

12 Months Ending

Sales in Millions

Change in Sales vs. Prior 12 Months

December 31, 2010

$597.5

391.9%

December 31, 2011

$1140.1

90.8%

December 31, 2012

$1281.3

12.4%

December 31, 2013

$873.3

-31.8%

March 31, 2014

$777.7

-36.5%

Click to enlarge

Source: SEC

We believe the company's explosive growth days are behind it. The drop in revenue from 2012 to 2013 resulted from a sharp drop in the number of its players. The downward trend continued in Q1 2014.

Its Facebook revenues were $655 million in 2013 and just $99.1 million in Q1 2014 ($396.4 million annualized). Mobile revenue was stable at $209.6 million for 2013 vs. $52.1 million for Q1 2014 ($208.4 million annualized). The $97.3 million drop in sales in Q1 2014 was due to reduced interest in Zynga's core games: the Ville series and Zynga Poker and not because of any decline in the gaming market.

According to Facebook's 2013 10-K, game developers received $2.1 billion in revenue in 2013. Reportbuyer.com expects the gaming market on Facebook to reach $5.6 billion in 2018 for a CAGR of 21.7%.

AppLift/Newzoo project mobile gaming will grow at a CAGR of 27.3% through 2016 to $23.9 billion. IDC's estimate is $23 billion by 2017 which results in a CAGR of 17.2% vs. 2013. We believe the higher projection is more likely to be correct because this market has a history of growing faster than expected.

But how much of this growth will Zynga share in? Since Mattrick is focused on mobile, probably little of the Facebook growth. This analysis assumes that the earnings power of its core franchise properties continues to fall as players continue to prefer competitors' games. The bulk of the sales growth comes from mobile, but its mobile sales grow slower than the market.

For 2014, Zynga's Facebook and other social media sales decline 36.5% year-over-year [YoY], incorporating its Q1 results and assuming no further sales decline. Sales fall another 10% in 2015 and then level off in 2016. Thereafter, these revenues grow at the rate of growth of the economy-2.52% (the risk-free rate).

Last year, Zynga's mobile sales grew 11%, up 22.4% vs. its 2012 mobile sales growth rate. The analysis assumes that Zynga's mobile sales growth rate in 2014 is unchanged from 2013 due to competition. Consistent with its performance in Q1, NaturalMotion's contribution to 2014 sales is small, amounting to just $8 million in 2014. Allowing for NaturalMotion's development of some relatively successful games in subsequent years, mobile sales grow 12% in 2015, 13.5% in 2016 and 15% in 2017. After 2017, mobile sales growth gradually decline annually until they are equal to the rate of growth of the economy in 2023--2.52%.

Zynga's Projected Sales for 2014-2023

Year

Projected Sales in Millions

Year-over-Year Change

% Mobile Sales

2014

$662.1

-24.2%

36.4%

2015

$647.8

-2.2%

41.5%

2016

$683.0

5.4%

44.5%

2017

$737.0

7.9%

47.2%

2018

$790.8

7.3%

49.1%

2019

$842.6

6.5%

51.0%

2020

$890.3

5.7%

52.4%

2021

$931.8

4.7%

53.4%

2022

$965.5

3.6%

53.8%

2023

$990.0

2.5%

53.9%

Click to enlarge
  • Adjusted Operating Margin Improvement and Sales-to-Capital Ratio

In Zynga's only profitable year, its adjusted operating margin was 25.8%. To achieve this margin again, Zynga would have to reduce its R&D expenses from 49% of sales for the TTM to the 25% it posted in 2010 and reduce the sum of its sales & marketing [S&M] and general & administrative [G&A] expenses from 36.6% for the TTM to 25%. We don't believe the company can meet these targets.

A more reasonable target for its adjusted operating margin is 12.9%. The company could reach this target by reducing its R&D expenses to 28.5% of sales and its G&A to 19.1% of sales from 22.8% for the TTM. This analysis assumes that Zynga gradually improves its adjusted operating margin and reaches the target of 12.9% by 2023.

Finally, it was assumed Zynga increases its sales-to-capital ratio from 0.64 to 1.3.

Other Intrinsic Valuation Assumptions

Based on Zynga's geographical sales breakdown as provided in its 2013 10-K, capitalizing its operating leases, using 2.52% as the risk-free rate, the initial cost of capital is 10.40%. After 10 years the firm earns its terminal cost of capital [COC], which is 7.02% after 2023.

R&D expenses were capitalized over a 2 year period. After capitalizing both R&D and operating leases, the company's initial pre-tax operating margin was -8.22%.

From 2014 through 2023, Zynga's net operating losses cover its profits and the company pays no taxes. After that, its tax rate is the US marginal tax rate (40%).

Intrinsic Valuation Results

Based on these assumptions, sales in the terminal year are $1.02 billion. The DCF results are tabulated below. All amounts are in millions.

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

Sales

$662

$649

$683

$737

$791

$843

$890

$932

$965

$990

Operating Income

-$40.4

-$25.9

-$12.9

$1.7

$18.5

$37.5

$58.4

$80.8

$104.2

$127.7

Net Operating Income

-$40.4

-$25.9

-$12.9

$1.7

$18.5

$37.5

$58.4

$80.8

$104.2

$127.7

Reinvestment

-$162

-$10.9

$27.1

$41.5

$41.4

$39.8

$36.7

$31.9

$25.9

$18.9

FCFF

$122

-$14.9

-$39.9

-$39.9

-$22.9

-$2.3

$21.8

$48.9

$78.3

$108.8

Click to enlarge

Zynga's estimated intrinsic value is $1.6 billion or $1.80/share. Based on its closing share price on July 31, 2014 of $2.92/share, the stock is overvalued by 61.8%.

Disclosure: The author is short ZNGA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is long KING.