Last time I discussed Facebook (FB) and its prospects for mobile monetization. Today, I was struck by many people discussing why Zynga (ZNGA) is a good play. There were even some articles on this site discussing why ZNGA is an attractive play now, based on balance sheet arguments or takeover speculation. Let's dig further.
I hope in this process to emphasize a key rule in investing: know exactly what you are getting into, and know whether your investment thesis is based in reality or fiction.
So let's look at this article from Eric Savitz:
... the market is basically saying it simply does not see any long-term value in the company's ongoing business. Zero. That's startling.
I've never been a big believer in Zynga's business; the barriers to entry in the gaming market are low, gamers are fickle and casual gamers even more so, and I think the rise of gaming on mobile devices poses a fundamental challenge to their business. And it is slightly mortifying to me how much time people waste on pursuits like managing imaginary farms. But the company does have over 300 million monthly users, and it has generated $653 million in revenue over the last 6 months.
But at some point, you have to wonder if some opportunistic buyer doesn't look at Zynga's valuation and conclude that buying it would be a quick way to gain a foothold in the social gaming market - and given the hard assets Zynga has, the risks would be relatively low. I wouldn't bet the ranch here, but Zynga shares are starting look like an interesting speculation for the adventuresome investor.
There are two major logical inconsistencies here.
First: if the barriers to entry are low (and given the spate of recent acquisitions, clearly there are firms in the space), and hits can emerge very quickly (from the press release, "In the six weeks since Draw Something launched, it has been downloaded over 35 million times."), why would a buyer need Zynga to gain a foothold in the social gaming market? Why wouldn't they develop it organically? Is six weeks too long to wait?
Second: If you don't understand why users are playing Zynga games and spending money now, why don't you think those users would leave for the next great thing if a new firm comes out with something new? It's really unknown where Zynga would be if they didn't acquire other firms like OMGPOP and Buzz Monkey. Would we see 300M users? That's not well known, and the market is reflecting the same exact skepticism that the author expresses.
Next up is an article discussing a Zynga takeover. The author gives three potential acquirers:
- Google (GOOG), because of partial ownership and as an attempt to waylay Facebook. Were such an acquisition to play out, and were Google to cut the cord, Zynga would lose most of the network effect and advertising cycle that led it to prominence in the first place. A Facebook-less Zynga looks pretty hairy, given the anemic uptake of Project Z.
- Apple (AAPL), because "Zynga games are prominent on our iPads as well as Facebook." That's a terrible argument. Up until recently, Apple has been very strategic and very selective in its acquisitions, buying technology that reemerged as features (for example, Siri). Buying Zynga may dissuade other game developers from focusing on the Apple platforms (after all, other developers would have to compete with in-house games)
- Facebook, with the author speculating that Zynga might be given a boost if they were owned by FB directly. However, this risks alienating other game developers on the FB platform, and it's unlikely that FB would shell out $2B for a firm that is not a direct competitor (like what Instagram could have been) and won't necessarily bring lots of talent. Again, the ecosystem is important.
The author concludes by arguing for the "potential for a company that seems (for the most part) to produce widely popular games that can generate not only ads but also revenue." The changes in Facebook advertising hurts firms who depend on the existing user base to move over to new games, which essentially is the position Zynga finds itself in.
Another author seemed to believe that "the bar has been lowered so much, and the stock has been hit so much, that it may provide an opportunity for investors looking for a long-term speculative play." Just keep in mind the same thing was said of MF Global (OTC:MFGLQ) and Eastman Kodak (EKDKQ), both of which are bankrupt now.
Yet another author lauded Zynga, basing arguments on a few factors:
But here's the thesis why I bought Zynga:
- Zynga is cash flow positive (although all of it comes from paying employees with shares);
- ... (the P&L overstated the value of the vested shares);
- Zynga has a lot of cash on its balance sheet. ...
In short, right now there's a potentially large and profitable social gaming business available for just 0.5 times sales. This should be very attractive to other players in the space, such as Electronic Arts (EA) or even Facebook itself. These could certainly make a move for Zynga if they recognize all that cash on the balance sheet makes the acquisition of the whole company very, very cheap.
All of these arguments are baseless:
Zynga being cash flow positive is a retrospective measure. To be cash flow positive in the future, there is a critical assumption that users won't drop off. Were another game to gain traction (like Draw Something from OMGPOP), they risk losing much of their user base or being forced to shell out millions to acquire the firm.
Cash on the balance sheet is meaningless if it can't be deployed well. And as others have argued, Zynga stock price is close to cash value.
Recent statements from EA suggest that they think they can win the social space organically, without having to buy Zynga.
Finally, I would like to point to an interesting rant by a user. I personally do not understand the allure of the games, but the fact that players feel such negative sentiment suggests that we should not assume the usage numbers will be rosy going forward.
Recommendation: Sell ZNGA if you have shares. Start shorting on any bounce.