Market Fails To Price Zynga As A Gambling Company

| About: Zynga (ZNGA)

Some of my favorite trades involve stocks that the market forgets are comparable. Eventually when the market remembers that a set of stocks is comparable, stocks that recently moved will affect the share price of those forgotten comparable stocks that were left behind.

Right now, people have forgotten that Zynga (NASDAQ:ZNGA) is a gambling company. Obviously, Zynga doesn't do gambling now, because it's illegal (in the US). We don't just value companies on what they're doing now; we want to know what they'll be doing in the future. Zynga is positioned to profit from the legalization of gambling. Zynga understands the appeal of poker. In fact poker was Zynga's first game! But Zynga isn't just any gaming company. Zynga incorporates tokens (like poker chips) within its games. That's Zynga's business model: hook you on the game, like Mafia Wars or Farmville, and you have to pay for tokens to get deeper into the action. Does that sound familiar to you? Poker chips? Perhaps you remember advertisements from Poker Stars enticing you to get started playing for free? Companies like Poker Stars brought in billions until they were shut down for illegal gambling.

Now clearly, if you want to gamble online, you're going to want to do it with friends, and who better to deliver the service than the dominant force in social gaming? Is Facebook going to build its own gambling app? Unlikely. Facebook's strategy is to build the infastructure to allow third party developers to do its bidding. This "outsourcing" allows Facebook to capture more user time because it allows Facebook to develop a wider range of apps. Zynga's also integrated with Google+ and other networks, by the way.

Think about it. If gambling is legalized, what reason would Zynga have not to get into the action? Poker is a social game. Zynga is the world's leading social game developer. Zynga has strong leadership. Zynga is a public company with a fiduciary duty to maximize shareholder value; but even more realistically, I'm sure Zynga executives want to get richer. The question is not why Zynga would consider moving into online gambling; the question is, why would Zynga consider not doing it? How is Zynga, a social gaming company in the United States, less qualified to enter United States gambling, than say, online gambling companies in Europe? We're talking about a US customer base. Who's going to mine that base best for mainstream users: some European poker site you've never heard of, or the #1 social gaming site--who by the way got its start with poker.

As you probably already know, online gambling stocks got a boost on news that the US federal government is allowing States to operate gambling websites to sell lottery tickets. Here are some gambling stocks; the blue one is Zynga.

So Zynga was left behind in the move of gambling stocks.

The market doesn't see Zynga as a gambling company. The market sees Zynga as 1) a social media or cloud company, and 2) a videogame company. Cloud/social media IPO's are unpopular by default because they have undergone violent deflation in recent months, and because there is a lack of historical data to use in establishing expectations for growth. In terms of the second criterion, being a videogame company anchors Zynga's market cap to comparisons with companies like Electronic Arts (ERTS), and Electronic Arts has a lot it needs to prove before it goes anywhere. So the two ways the market sees Zynga are both quite pessimistic right now. I don't have a problem with that. My problem is, there are lots of reasons to be pessimistic about all stocks, but when positive information arises, it should get its fair hearing in the valuation.

To take advantage of this mispricing, you could buy Zynga. The question is, do you want to hedge this exposure, and if so, how?

There are now three elements to Zynga: social/cloud, videogames, gambling. There are abundant opportunities to bet against any of these. If you want to strictly take advantage of the Zynga mispricing, you could buy Zynga and hedge it with a little short exposure to all three. If there is one of the three elements you are particularly concerned with, you could overweight that in your short exposure.

Personally, I'm just buying Zynga.

I can tell you why the market doesn't see Zynga as a gambling company. It's because Zynga doesn't do gambling at the moment. The market seems to have difficulty comparing future activities in high P/E stocks. The market knows how to "skate to where the puck is going", but sometimes it makes mistakes figuring out which pucks are magnetically linked. (Sorry, I couldn't resist the puck analogy.) Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ZNGA over the next 72 hours.