Seeking Alpha
Recommended for you:
Long/short equity, deep value, special situations, contrarian
Profile| Send Message|
( followers)  

Remember in 1999, when analysts were trying to invent all sorts of crazy models to try to explain why .coms had the valuations they had?

Well I tried doing the same when the Zynga IPO was priced. I tried many different formulas and models and tried to persuade myself that the market is not crazy and that I was wrong for daring to question the price that everyone was wiling to pay to get their hands on Zynga Stock.

Well, it turned out I was not that crazy and it turned out that indeed the Zynga IPO was priced for pie in the sky. It also turned out that those investors who time and time again don't pay attention to valuations time and time again lose money.

Zynga (NASDAQ:ZNGA) is a great company. However, great companies don't always make you money if you overpay for them. And that's exactly what everyone on the street did when they subscribed to the IPO.

Zynga yesterday surprised everyone (once again) by lowering guidance once again. The company said it expects to report a net loss of $90 million to $105 million for Q3. Also, revenue is expected to be about $300 - 305 million for Q3. What this means is that the revenue growth and profit expectations that were priced into this stock, are there no more. Three straight quarterly losses is not what the market had in mind nor priced in.

The declining popularity of some of the company's games are only part of the problem. The company has announced many new offerings and has a good pipeline of games, but somehow it has failed to deliver. On top of all that, it was reported yesterday that developers of "Words With Friends" have left the company. The fact that top level executives have recently left the company is also not a compliment.

However, all of this is ancient history. The fact is that all of these issues are either priced into the stock, or almost priced in. The question at hand is what do investors do from here on end?

The company's balance sheet is solid. The company as of Friday has a market cap of about $1.9 billion, which is more or less in line with book value. So theoretically investors at these prices do not pay for any hot air like those who subscribed to the IPO. It does not mean that the stock can not trade below book value, but investors at these prices at least have a cushion.

The social game business is here to stay. I don't think that Zynga is going anywhere anytime soon. The 300 million users the company has is a great asset. Just because the company can't monetize this asset enough does not mean that this asset is not worth something, or that this asset can not produce a fantastic revenue stream in the future. Maybe the company has to diversify from social gaming to something else..

You all know that Zynga is diversifying into the online gambling space. This is not a secret and it is something that many people have been talking about for over a year now. However, as with many things in life, many issues are a matter of timing. There is a good chance that the issue of timing is now in Zynga's favor. Let me explain.

There is a proposed bill called the The Internet Gambling Prohibition, Poker Consumer Protection, and Strengthening UIGEA Act of 2012. The main purpose of the bill is do some house cleaning in the online gambling space. The other purpose is to produce revenue for federal and local governments. Here are some excerpts from the proposed bill:

Under the bill, all Internet gambling, whether interstate or intrastate, would be prohibited, except off - track horse-race wagering under the Interstate Horseracing Act of 1978 and licensed poker. State and tribal lotteries could sell lottery tickets online but could not create online games that mimic a slot machine or other casino games. Offering unlicensed Internet gambling would constitute an express crime under the bill - subjecting the offender to up to 10 years' imprisonment and accompanying ines - and under the Wire Act, the Illegal Gambling Business Act, and UIGEA

The key word here is unlicensed. The government intends to put some order in the space through some kind of licensing scheme.

The bill adds important tools to aid law enforcement in preventing illegal Internet gambling. Among these tools is a list of licensed online poker enterprises. Financial transactions providers may only process U.S. transactions for online poker enterprises that are on that list

The above is very important. Again, key words are "licensed online poker enterprises." So if you are Citibank and a poker company comes to you for payment processing, Citibank will verify if you are a licensed poker company. If you are not, Citibank cannot process payments for you. Automatically, this means that many companies who provide poker at off-shore locations will more than likely be blocked from doing business in the US.

And the main reason for the bill is money …

The bill establishes a 16% online poker activity fee payable by licensees on a monthly basis - 14% payable to the states or tribes and 2% to the federal government with an adjustment mechanism to redirect any unused portion of the federal fee to the states or to establish additional funds - up to a maximum of 3.5% - if necessary to fund the permitted federal uses.

I live in Europe and by chance I know people in this industry. Most companies that deal in the online poker or gambling space are in Malta or some other jurisdiction that you never heard of, because these countries have set their legal framework in such a way as to accommodate these companies to do business there and to bring revenue. Revenue of course that is shared with governments. And because online gambling is big business, both the US and Europe have decided they want a piece of this revenue.

Where does Zynga fit in all this? Well I am betting that Zynga will eventually be one of those licensed companies that will be allowed to offer gambling services across the US. Yes there might be other companies out there also, but there is no one better positioned and with a bigger online gaming clientele than Zynga.

And how big is online poker and other sorts of gambling? Well according to the House Ways and Means committee, in a report they published on April 15, 2010, titled, United States Internet Gambling Economic Impact Assessment:

Should all forms of Internet gambling (including sports betting) be licensed and regulated in the largest 12 potential US state markets H2 have concluded that $65bn would be generated in gross expenditure in the nation's economy over the first five years. This in turn would create approximately 113,030 FTE job years (an average of 13,730 direct/8,880 indirect per annum) and $26.6bn in domestic taxation during the first five years.

One can disagree with the numbers, but the bottom line is that online gambling is big business. All Zynga needs is to capture a small piece of this steam and this stock will see much better days.

The question however is, assuming all this plays out, is Zynga up to the challenge? Well again, what will happen remains to be seen, however I think Zynga is better positioned than most to take advantage of this space.

Bottom line: Depending on the legislative outcome and depending on how Zynga's management "play their cards," this new gambling framework in the US might turn out to be just what the stock doctor ordered for Zynga's shareholders.

Again, assuming I am right that the company is better positioned than most and assuming that indeed Zynga will be one of those licensed companies in the online gambling space, there is the possibility that this stock can see substantial appreciation in the future.

Investors need to keep an eye on the gambling space and on Zynga, for the rewards will be substantial for all those who follow developments and do their homework and position themselves ahead of the crowd.

Source: Zynga: From Social Gaming To Gambling?