I'm going to start this article with a story about the title and in particular why it's "2". A few months ago, Zynga (ZNGA) had their "Zynga Unleashed" day where they showcased their upcoming new games and updates to existing games that ultimately resulted in the stock price plunging something like 15% by the end of the event. I don't want to spend a lot of time explaining why the Street was underwhelmed, but in general most of the announcements were about "ville" games, and I assume the Street was hoping for something more exciting. My first thought when I watched the stock plummet was: "that went over like a lead balloon." My second thought was: "that would make a great title for a Seeking Alpha (SA) article, let me try to get one out before someone else beats me to the punch." I really did believe the Street overreacted and wrote an article that I think made valid points, but in order to get it out quickly, I focused on opinion and avoided stats that I would have to research.
I'm sure people who read SA articles often know that opinion pieces do get published fairly regularly on SA, but as an author with a grand total of two SA articles to his resume, I wasn't getting a pure opinion piece past the SA editor who reviewed that article. His suggestions were pushing me toward a data and fact based article. Luckily for me I don't make my living from writing and I was too busy at the time to follow up, so that version of "Zynga Launches Lead Balloonville" is dead. Getting back to what this has to do with this article, I'm hoping to show with "data" that the Street's reaction to the recent earnings report and forward guidance is overblown. To be clear, I'm not trying to argue that there are no problems; however, I am going to argue that the magnitude of Street's reaction is based on "opinion" not "data."
In my last article on Zynga, I included a table of quarterly data covering fiscal years 2010 and 2011. I'm going to expand the table to include the first two quarters of 2012 and a new row for bookings to make my point in this article:
|Jun 12||Mar 12||Dec 11||Sep 11||Jun 11||Mar 11||Dec 10||Sep 10||Jun 10||Mar 10|
From this table, the only thing that's somewhat troubling is an 8% sequential decline in bookings in Q2-12. To be fair, this was not the primary reason the stock tanked after the recent earnings release. It was revised bookings guidance for the rest of 2012 of $1.15B-$1.225B that tanked the stock. If you take the midpoint of 2012 guidance at $1.188B and subtract the $0.631B bookings from Q1 and Q2, you get $0.557B for the rest of the year or ~$288M/quarter, which is about 12.5% below the March high of $329M in bookings. Certainly this is not good news, but was it worth a 40% haircut the next day? I'm going to show later that the skeptics' argument and implications of the share price are that this company is in a death spiral. What in the 2.5 years of results above implies this view is correct? 12.5% lower projected bookings?
To be fair again, another reason the stock tanked after this report was due to dramatically reduced non GAAP earnings guidance for the year. I don't remember the exact original guidance, but it was in the mid 20 cent range and was reduced to 4 cents to 9 cents a share. This is where some context is helpful though. Zynga is on a pace to spend ~$700M on R&D in 2012, up from $$375M in 2011 and $10M in 2010. This is relevant for two reasons. First, they could easily have maintained their earnings target by cutting back on R&D, but they think this money spent developing new games and updates to existing is important. To put the amount of money they spend on R&D in context, Electronic Arts (EA) does about 4X the revenues Zynga does at ~$4B/year, but only spends about 40% more on R&D at ~$1.2B/year. That means Zynga could halve their current R&D expense and still spend proportionally more than EA, and they'd be spending about the same as their 2011 R&D budget.
The second reason understanding their R&D expense is relevant is to understand how unfounded most of the commentary about Zynga is right now. Here's an example from a recent SA article:
"and the company's finances are in dire straits."
Really? They're going to earn 4 to 9 cents this year, they have ~$1.5B net cash and equivalents, they generated $146M in cash from operations over the first 6 months of 2012, including ~$67M in Q2. Even with the projected downturn for the rest of 2012, management still projects they will continue to be free cash flow positive for the remainder of the year. This is a company in financial dire straits? It's not just anonymous SA authors either. I was watching a video the other day with Betty Liu (Bloomberg I think) interviewing an analyst about Zynga with the headline something like" Zynga in death spiral." The analyst was suggesting Zynga would be toast in a few years, and after Betty prodded him about the possibility that Zynga bites the dust in the next 12 months, the guy entertained the possibility. Based on what?
I'm sure anyone who has stuck with the article this far is looking for a theme here and thinking I might be rambling a bit, but that's part of the theme. From what I read of Zynga commentary, lately there are a lot of people in the analyst community and the financial press that always assumed that selling virtual cows was a fad and Zynga's model was unsustainable, and it appears that the guidance for the remainder of 2012 was all the proof they needed to declare victory and write Zynga off. It's called confirmation bias. Right now, the Street has bought their version of the story hook, line, and sinker. Anything negative about Zynga is taken as fact. Just look at the "financial dire straits" that made it to SA. This gets back to my introduction to this article and the value of facts data and context vs. opinion and hyperbole.
So now that I've established my theme of facts, data and context vs. opinion and hyperbole, let's look at some more facts to further establish context. Zynga has $1.6B in cash and equivalents and a mere $0.1B in debt for a net cash position of $1.5B. At a market cap trading in the low to mid $2B range, the actual business is currently being valued at ~$0.5B-$1B. If you count the $0.5B in property and equipment, the business is being valued at almost nothing. A mediocre company should get a price to sales multiple of 2. Zynga's getting multiple of 0-1. In other words, this company is currently being valued like it's going out of business. Hopefully, I demonstrated with facts that this company is not remotely in danger of going out of business. To be clear, I'm not arguing Zynga is firing on all cylinders. My argument is that contrary to what the market cap of Zynga implies right now, this company is not in danger of failing.
I'm going to branch off on a different tangent one more time, but I'll be tying it back to the theme of context in the end. I think I understand the skepticism about Zynga's model because I had zero interest in Zynga until I heard an analyst on CNBC mention it as a baby being thrown out with the FB bathwater following the FB IPO. For some reason, I thought it was worth taking a look at. I found the relatively reasonable P/S multiple of 4X at the time (not discounting cash) interesting, but I worried about competition. But after thinking about it a little, it dawned on me that Pincus had already built a $1B revenue company from scratch over a few years in the midst of established giants like EA. Maybe this business was more robust than I gave it credit for. The other thing that struck me about the business model was the room for improvement and growth that I argued in previous articles. The consensus opinion is that this is a hit driven business model, but I'm going to point out a number of ways that Zynga can grow without the next monster game. Combine these with a stock price implying this company is about to file for Chapter 11, and the result could be a monster hit for investors buying in right now.
1. The increase in DAUs in Q2 while ABPU decreased proved a point I made in an earlier article (albeit opposite of what I hoped) that their gaming rewards model is not driven by overall sub activity but by a tiny minority of hardcore subs that choose to buy rewards. At a few percent of subs paying, there's plenty of room for improvement over time and with more experience and user data in this new model.
2. Although ad revenue is still not very significant, it's growing rapidly. If Yahoo and Facebook can generate billions a year with banner ads no one ever looks at, I don't see why Zynga can't get ad revenue into the billions with clever interactive ads worked into their games. Zynga put out a special version of Castleville themed around a cartoon movie about a castle that is a great example of where Zynga is taking advertising in their particular model. For context, ad revenue grew 46% sequentially from $28M Q1-12 to $41M Q2-12. Annualizing Q2, we get $160M which is not real significant right now, but look at the potential and the growth.
3. Zynga is launching their games in something like a dozen different languages to further international expansion. How many billions of people will this open their games up to?
4. They've signed up something like 29 independent game developers to their beta gaming platform over the last half year or so that it's been up, and bet your bottom dollar they'll eventually migrate their own Facebook customers to this platform and cut Facebook and their 30% out. Skype and YouTube became overnight success stories without Facebook promoting them. Zynga's reliance on Facebook is way overblown. Facebook is a platform nothing else. Zynga's got their own now, and they could afford to be on just about every commercial break on television 24/7/365 with the 30% they pocket from FB if they thought they needed promotion.
5. They are constantly launching new games and updates to existing games. Some of this is bound to do well. Getting back to competition, how many competitors can spend close to a billion dollars developing games? Hell a good number are partners anyway.
6. They'll be launching online gambling in Europe next year, although it will be in established markets, and they might need a partner with a license. It's still something when they are priced as if nothing will succeed.
7. I'll fall on my sword here and admit I don't know the details of the deal, but they have some sort of partnership with board game maker Hasbro (HAS) that sounds interesting.
So to wrap this up, I'm going to try to make the skeptics' argument. Zynga relies on just a few games for the bulk of its revenue, and the success they've had to date with these games was a flash in the pan. People are finally realizing they've been wasting their life away tending to virtual cows, and cow buying subs are about to leave en masse. 1-7 above are all nifty ideas, but they'll never amount to anything and therefore this business will shrink to something so small it might as well have gone out of business if it doesn't actually go belly up. Any price is too much for this stock because they'll never make a dime and they'll urinate the $1.5B away vastly overpaying for every acquisition they make and the businesses they buy will all flop like OMGPOP did (so far) anyway.
One of my investing heroes Bill Mann at TMF once wrote a story about a famous gambler. I don't remember his name but he was a bit of a character. When asked about his gambling success, he said you've got to know the 60/40 proposition. In other words, he was saying he made money understanding when the odds were in his favor. The only way the skeptics' case and the current market price for Zynga are right is if everything I pointed out above amounts to nothing. What are the odds?
Disclosure: I am long ZNGA.