Sell Zynga: Consumer Gaming Shifting From Social Media To Smartphones

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 |  About: Zynga (ZNGA), Includes: AMZN, DNACF, EA, FB
by: Bidness Etc

Zynga Inc. (NASDAQ:ZNGA) has been continuously deteriorating; the stock is trading near its 52-week lows and we can predict a further downside after viewing the shift in consumer preferences from social media games to smart phone games. Due to the company's poor performance and major shareholder mistrust, its COO, John Schappert, resigned from his position.

The stock is trading at high valuations as depicted by its five-year expected PEG ratio of 1.74. Our 12-month target price is $1.78 with a downside of 60%. The company is highly non-responsive in the competitive technological world and has failed to coup up with the changing people fondness towards the smart phones. Therefore, we recommend avoiding a long position on Zynga, while in our previous report, we had already proposed a short position on the stock. The stock is down $2 (40%) since then.

A decrease in the monetized user growth is reflected by a decrease in the booking rate, which has come down from 37.7% to 9.8% over the last one year. The underlying reason behind this has been the shift of Facebook (NASDAQ:FB) users from desktop computers to smartphones. According to a recent survey, smartphone users tend to play more mobile games as compared to social media games. 92% of the company's revenue is coming from Facebook. The shift in consumer preference towards smartphone games has created an alarming situation for the company.

The 55.14% decrease in operating income from 2Q2011 to 2Q2012 was mainly because of changes in the Facebook platform. The new Facebook 'timeline' has outdated Zynga's product recognition. Zynga has added three web games, but have still not been able to grab the attention of their target market, primarily due to ineffective promotion. Moreover, the company has decreased its R&D costs by 8.4%, which portrays its diminishing ability to respond to technological changes in the future.

The company's revenue growth rate has significantly declined from 90.8% to 4.2% from Q22011 to Q22012. The company makes money by selling "virtual goods" and "advertising in games". The company's games introduce competition between players, in order for them to progress and achieve their targets. In this way, Zynga takes money from players through Facebook credits. Therefore, due to a lack of interest of players, it has become difficult for the company to hold onto advertisers. Moreover, two major shareholders have filed lawsuits against the company because of mistrust against the management. The shareholders believe that the CFO misrepresented or failed to represent the company's growth prospects. In response to the allegations against its CFO, the company has started reshuffling its top management to enhance its financial position. But the reshuffling of the management is not enough to retain investor trust, as the company is accruing losses on its investments.

The company was not able to develop more attractive games, resulting in a deteriorating market equity. Incorporating the long-term point of view, if Zynga wants to regain its prior profitable growth levels, it has to consider options such as horizontal integration. The company was thinking of expanding its horizons by acquiring some of its small profitable competitors like ZeptoLab, the maker of the popular game 'Cut the Rope', and Rovio Entertainment, founders of 'Angry Birds'. These acquisitions will probably help the company regain its lost position and utilize its excessive cash to rebuild its competitive edge. If Zynga wants to monetize user growth, it has to launch a substantially attractive marketing plan to grab user attention. However, unfortunately, imprudent management decisions and lack of investor trust will probably darken the company's future.

Direct Competitor Comparison

ZNGA

Dena co(OTC:DNACF)

Elactronic Arts (NASDAQ:EA)

Market Cap:

2.2B

4.03B

4.14B

Qtrly Rev Growth (yoy):

19%

37%

-4%

Revenue ((TTM)):

$1.27B

$2.02B

$4.1B

Gross Margin :

71%

78%

62%

EBITDA :

-458.19M

909.38M

274.00M

Operating Margin :

-46%

42%

1%

Net Income :

-$512.48M

$445.9M

$56M

Click to enlarge

The robust financial position of competitors is putting Zynga under pressure. The company's operating margin of negative 46% is below its competitors, DNACF and EA. Amazon (NASDAQ:AMZN), by launching its first game on Facebook, further increased this competition. The company's average daily booking per average (DAUs) declined YoY by 10% from $0.046 to $0.051. Moreover, Zynga's online game revenue declined by $1.2 million in the last quarter. The company's Non-GAAP net income decreased by 90% over the last quarter and 88% when compared to Q22011. Its negative profit margin, along with a decreasing revenue growth rate of 19%, is a matter of great concern for the management. If the company loses its base on Facebook, it will be extremely difficult for ZNGA to register profits in the coming years.

The stock showed a significant downside of 50% over the last six months. As the graph given above depicts, EA is down by 10%, and DNACF shows an upside of 20%, in the last six months. ZNGA's 52-week price range is $2.66-$15.91. The stock is currently trading near its 52-week lows. The stock was enjoying good heights a few months back, and its four games were in the top ten of the most liked FB games.

Valuation

Direct Competitor Comparison

ZNGA

DNACF

EA

EPS :

$-0.99

$3.05

$0.17

P/E :

N/A

9.25x

76.47x

PEG (5 yr expected):

1.74

N/A

0.69

P/S :

1.77x

2.1x

1x

Click to enlarge

Despite having strong industry growth, considerably high franchise value, and large amounts of cash, the company has not been able to translate its business strategies into profits.

The stock is current trading at P/S of 1.77x, at a discount when compared to DNACF's 2.1x and at a premium when compared to EA's 1x. The stock is trading at high valuations, as depicted by its five-year expected PEG of 1.74. The changing Facebook platform has had a remarkable impact on Zynga's sales, and makes the company least attractive for investors.

Looking forward, it is unlikely to see a significant upside until the company shifts its focus from social media networks to the smartphone platform. The decreasing R&D expenditures portray the company's lack of product development in the coming period. We do not recommend investors to take a long position in the stock until the company discloses proper business plans, operations, and growth prospects.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Technology Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.