I recently wrote a big picture themed Zynga article. This was my first ever published article on Seeking Alpha or anywhere else other than blogs and message boards. After I submitted it I thought about how I might have written the article differently but I wasn't really considering a follow up until I saw the news the other day regarding Cowen analyst Doug Creutz detailing the current downtrends in daily active users for Zynga's games. Here is a quote that I have to admit, spooked me a bit when I first read it:
Cowen analyst Doug Creutz points to the fact that nearly all of the company's major titles posted "significant" month over month declines in daily active users, and that May marked the second consecutive significant month over month drop.
As an investor focused on fundamentals I went back to my thesis for placing some chips on Zynga (ZNGA) and this quote from Wedbush analyst Michael Pachter sums up why I'm not hitting the panic button on these numbers.
And Wedbush's Michael Pachter tells me that it's more important to focus on the number of gamers who are paying to play. He says it makes sense that user numbers for a game like Draw Something would drop off - people who aren't good at drawing will simply stop playing. But the people who do stick around are likely to pay more to improve their gaming experience.
This is the same case I was making in my debut article and I'm going to publish some data below to hopefully demonstrate this argument. The information below is taken from Zynga's 2011 10K and the full definitions of DAU's and ABPU can be found there but DAU is "Daily Average Users" and ABPU "Average Bookings per User" (the amount of money they book per day per user).
Zynga Financial and User Data
|Dec 2011||Sept 2011||Jun 2011||Mar 2011||Dec 2010||Sep 2010||Jun 2010||Mar 2010|
In regard to DAU's there seems to be a kind of seasonality to this metric but more importantly it's about break even to slightly down over the two years covered while revenues have tripled over the same period. DAU's is the metric that Doug Creutz is concerned about but I think it's pretty clear that growth in DAU's is not what has been driving revenue growth for Zynga. ABPU or money "booked" per sub per day has doubled over the same period. I use revenues in my chart above because I thought it would be easier for more readers to understand however the difference between bookings and revenue is that bookings account for changes in deferred revenue. Bookings doubled over the two years matching the increase in ABPU. In my opinion ABPU is the key metric to watch for Zynga and this is what Pachter and other analyst out defending the stock today are talking about when they say the key is monetization of the sub base not over all user activity.
I think another important takeaway from the numbers above is that ABPU didn't go up in a straight line. This gets back to the argument in my first article that improvement in monetizing their gaming reward system and working advertising into their games is an evolutionary process. In other words it's a process of trial and error slowly building on the things that work. One of Mark Pincus' talking points lately that resonates with me is the concept of "evergreen" games. These are games that maintain an active base over the long haul. They don't need every game they introduce to be an evergreen but hitting on one here and there adds up over time. As they start hitting on successful ways to get subs to pay for rewards and work advertising into the games they should be able to translate this to other games in a similar evolution of these two revenue generating systems.
Because the financial media usually correlates Zynga to Facebook and it seems like large numbers of investors seem to believe "social" business models are all the same I'm going to make some comparisons to Facebook (FB) which my alter ego (MKArch) in The Motley Fools CAPS stock picking competition wrote about pre IPO. My thesis to red thumb the then upcoming stock IPO was that Facebook's business model of selling banner ads with a below average click through rate is comparable to Yahoo not a Google. Unfortunately due to Wikipedia's format of updating entries, the Facebook click through rate information I cited in my blog is no longer available on the Facebook Wikipedia entry but here is another source with similar numbers. Facebook's product may or may not be revolutionary (MySpace) but it's current "business model" is not revolutionary. Banner ads have been around for over a decade and despite losing some ground lately (Likely to Facebook) Yahoo is the standard bearer for the banner ad model and that's about the upside to Facebooks current business model. $6B-$8B/ year in revenues a billion or so in earnings and a market value in the mid teens to mid twenty billions. At Facebooks current market cap that would be quite a fall from grace.
I will discuss valuations more later but I've seen two defenses for Facebook's current lofty valuation and both come across as weak to me. The first is that Facebook has some treasure trove of information that they can use to create more effective advertising. As I point out above the reality is their ads are very ineffective and it's likely that what ever information they gleen from users pages is superficial and this is why reality is not consistent with the theory. The second argument is that they'll figure something else out to monetize their 900M users. That's great but when your current business is probably worth about $20B when it's mature and you already sport a market cap around $60B that something else needs to be a pretty darned good business. For a frame of reference take a look at the charts for CSCO, MSFT and INTC from 2000 to the present. All three were already large cap companies and sported multiples similar to FB when they were leaders in markets that were hot at the time and all three have substantially grown their revenues and profits since then but not enough to account for their sky high valuations at the time. The three were also all going to figure out something different that would justify their lofty price tags.
Right now the market seems to be realizing the problem I saw with Facebook's model in that there's no way to improve on the effectiveness of banner ads. They are what they are, if there was a way to make them more effective you would have seen it by now. Contrast Zynga's models and there are all kinds of ways they can improve gaming rewards and incorporate advertising into their games. In my last article I mentioned potentially working in a sponsorship deal with an art supply store like Michael's into their Draw Something game. The suggestion was to have Draw Something's users shop for supplies for different media in a virtual Michael's or other art supply store. These companies could also sponsor periodic art competitions in different media and promote periodic special offers and sales to draw something users. The idea is that advertising is targeted and interactive which should make it much more effective than banner ads. Here's an interesting version of this working Martha Stewart Omnimedia into their Castleville game. On the gaming rewards side, here's another freebie idea to better monetize their Zombieswipe game. Let users create their own zombies that they can set loose on other members of their user groups and pay for enhanced features for their super zombie creations. Maybe they personalize them with uploads of head shots (pictures) of themselves that get added to their custom zombies. In order to maintain interest Zynga can set up periodic competitions that user groups can enter where they set zombies loose on each other and award prizes.
Getting back to the Facebook comparison Zynga currently sports ~$3.7B market cap compared to ~$58B for Facebook and Zynga sports a fairly average P/S ratio of 3 to Facebook's still extremely optimistic 14.5 P/S ratio. Zynga's Gaming revenues are about $1B/ year with advertising revenue at an insignificant $75M in 2011 but accelerating quickly. As I argued in my last article I think if Facebook can do $4B/ year in banner ad revenue Zynga can get more targeted ad revenue in the billions and can also do significantly better with gaming rewards as this system evolves. Just as a point of reference Facebook currently has 443M daily users and did $4B in revenues last year. That works out to ~$0.025 per day per user for banner ads. With ~55M DAU's that would translate to ~$500M/ year in revenues for Zynga however with their targeted interactive ad model I think they can ultimately do a whole lot better than $0.025/ day/ active user. The point I'm trying to make in this comparison with Facebook is that contrary to recent headlines these are two completely different business models and valuations and this matters greatly to their investment potential. User metrics similar to the one Creutz cites probably mean a lot to a Facebook investment because absent some new business they're growth is probably largely tied to sub growth and user activity although they did announce an intent to add more advertisements to user pages recently. I suspect this is due to a lack of better ideas on how to monetize their subs. As I've tried to demonstrate sub growth and user activity is not as important to Zynga and at their current market cap they don't need to figure something else out to be a good investment as I'll try show next.
Finally here's a little back of the napkin valuation based on what I think are some fairly achievable assumptions. In my last article I ball parked $5B total revenue in five years based on a $1B-$2B/ year in ad revenue and $3B-$4B/ year in gaming reward revenue. Right now gross margins are ~70% but cost of revenues is based on expenses related to numbers of users like the cost of Hosting. Since I'm counting more on improvements in monetization not massive increases to the sub base I'll ball park cost of sales only triples to about $1B/ year, resulting in a gross margin of ~80% and a gross profit of ~$4B. I'm assuming R&D about doubles to ~$1.5B/ year which is similar to Electronic Arts (EA), the same with G&A and we are left with ~$1B operating profit and ~$0.65B net income. Give that a 25 multiple and you're looking at on the order of $16/ share. To simplify things I assume cash and dilution about offset each other. Discount that $16 back to present value at 11% and you're looking at something like $9.5 fair value. Right about the IPO price. On top of this you have the option value of legalized online gambling and something I think is a strong possibility that rewards and advertising do a lot better than I assume for the purpose of this back of the napkin exercise. They have no debt and $2/ share in cash, so I don't see a whole lot of downside from here or at least none that's lasting and a lot of opportunity for upside.
Disclosure: I am long ZNGA.