Lately, everything seems to be going wrong for Zynga (ZNGA). They're facing multiple lawsuits, their top executives are leaving the company, and they missed analysts' earnings expectations for Q2 2012. But I'm willing to bet that their stock won't drop much further between now and January 2013. I'm selling January 2013 $3.00 puts for about $0.55 per share, which means that I will profit from this trade as long as ZNGA remains above $2.45 when the options expire in January.
Is ZNGA worth $2.45 per share?
In order to determine whether I will lose money on this trade, it's important to understand what ZNGA is worth. Let's first take a look at ZNGA's balance sheet. According to their latest 10-Q, they have current assets of $1,450,272,000, long-term marketable securities worth $426,243,000 and property & equipment of $499,426,000. It seems that most of their long-term marketable securities are invested in U.S. government debt, which is a pretty safe place to be, and the majority of their property & equipment is attributable to land and real estate, including their new corporate headquarters in San Francisco. These aren't exotic derivatives contracts that are going to explode overnight, these are relatively stable assets which will retain value.
Let's then assume that their goodwill and intangible assets are worth nothing. This is a ridiculously conservative assumption, because as a social gaming company, their business is in creating intangible value via the network effect of their games. However, for the sake of creating a margin of safety, let's assume that their brand, their user base, and their recent OMGPOP acquisition are all worth nothing. So we add the above three numbers to get a total fire sale value of their assets of $2,375,941,000.
Now let's subtract their total liabilities of $861,743,000. We get: $1,514,198,000. Based on 759,631,990 shares outstanding as of July 13, 2012, this equates to a bare minimum of $1.99 per share of tangible value if ZNGA were to immediately cease all operations and liquidate its assets today.
Which means that at a cost-basis of $2.45 per share, I am buying ZNGA's trademarks, intellectual property, user base, future cash flows, and the multi-billion dollar growth potential of its online gambling operations, for just $0.45 per share (approximately $342 million). To put this into perspective, ZNGA spent $358 million in research and development during just the first two quarters of 2012. If at any time they wanted to stop investing into their future, they could immediately lay off most of their workforce and report GAAP earnings well in excess of $0.45 per year, although these profits would not be sustainable.
However, I am not buying Zynga for $2.45 today, I am promising to buy it for $2.45 in January of 2013. Between now and then, it's possible that the company will lose more money, which would decrease the net tangible value of its assets.
How much money could they lose?
Between now and January 2013, ZNGA will report its earnings for only one quarter - Q3 2012. We can look to their earnings history to guess how much they could lose during Q3 2012. Zynga, while not tremendously profitable, has not been tremendously unprofitable either, except for Q4 2011 and Q1 2012, during which they incurred big expenses related to their IPO and secondary offering.
Excluding Q4 2011 and Q1 2012, their worst quarter was Q4 2009, during which they lost $24.55 million on a GAAP basis. This amounts to about 3 cents per share. Even if Q3 2012 turns out to be as bad as Q4 2009, this would only result in a 1.5% reduction in the company's tangible book value. So if Zynga is indeed a sinking ship, it's going to be sinking at a glacial pace. Which is why I strongly doubt that it will trade anywhere near $2 per share before January.
Meanwhile, user growth is stable.
Revenue is also stable.
All lockups have expired, and anyone wanting to sell has had plenty of time to do so.
There are 19.32M shares short as of August 15, 2012. Due to ZNGA trading so close to its tangible book value, short sellers are faced with an inadequate risk/reward ratio when deciding whether to retain their short positions.
Lastly, ZNGA has the largest free-money poker room in the U.S. If you believe that ZNGA is well positioned to take advantage of the lucrative growth opportunities in real-money online gambling, you may want to buy long-dated call options instead of selling January puts. This is especially tempting because the implied volatility of ZNGA's options is currently much lower than its historical volatility.
The elephant in the room is that Mark Pincus controls over 50% of the shareholder vote through his Class C shares. Like Facebook (FB) and Google (GOOG), ZNGA has a multiple-class share structure designed to protect the autonomy of its founders. This means that you must trust Mark Pincus to competently serve shareholders' interests despite a lack of oversight. Although he isn't nearly as good of a CEO as Mark Zuckerberg or Larry Page, I believe that it's unlikely Mark Pincus will be negligent enough to destroy $350 million of value within the next 4 and a half months, especially when much of his wealth is locked up in ZNGA stock.
Additional disclosure: This is a speculative trade, and I strongly advise that you do not allocate a significant percentage of your portfolio to it. Please do your own due diligence.