Zynga (ZNGA) is the world’s largest social gaming company with around 306 million monthly active users. Its most popular offerings include FarmVille, CityVille, Texas HoldEm Poker and Mafia Wars. Despite the popularity of Zynga’s games, the company’s stock has fallen from March 2012 highs of $16 to as low as $2.21 during October 5, 2012.
We recently revised the Trefis price estimate for Zynga from $6.15 to $3.30 based on slower than expected growth in the company’s average revenue per user (ARPU), lower gross margins and our expectation that expenses like SG&A and R&D will be higher as a percentage of the company’s overall revenues leading to lower EBITDA margins over our forecast period.
Despite our lowered outlook, there is still an opportunity for greater upside for Zynga given that Zynga’s cash on hand now constitutes a significant (80%+) fraction of Zynga’s stock value and that the company’s mobile initiatives combined with new games can provide the revenue and margin growth investors are looking for.
Below we highlight in greater detail why Zynga’s stock has fallen over the past few months, how we’ve updated our projections and where there may be opportunities for Zynga to be valued higher.
Zynga Stock Rises & Falls with Shifting Guidance, OMGPOP Acquisition & Facebook (FB) Policies
Positive Guidance in February 2012
On February 14, 2012 Zynga issued optimistic guidance, stating that adjusted EBITDA would be in the range of $390-$440 million and the EPS would be in the range of $0.24 to $0.28 for fiscal 2012. The market took this as a positive sign and the stock hit highs of $16 and then traded in the range of $13-$15.
OMGPOP Acquisition in March 2012 & Improved Guidance Outlook in April
The company had a growing user base and a near monopoly of the Facebook gaming market, and it seemed as if the company couldn’t do anything wrong as it announced the acquisition of OMGPOP, the maker of Draw Something, for $200 million on March 2012. This acquisition added nearly 35 million users and strengthened its presence in the mobile and tablet market. The company expected this jump in user base to improve its FY 2012 figures and on April 2012, it improved its guidance and announced that its adjusted EBITDA will be in the range of $400-$450 million and the EPS will be in the range of $0.23 to $0.29.
Approximately 50% Cut to Adjusted EBITDA Guidance in July 2012
Zynga’s sales and marketing expenses went up as Facebook changed its policies and the social game maker lost users when Facebook changed the way it displayed games. The company initially held top spots on Facebook as the company displayed its games based on popularity and users. However in order to attract users to more games, the company changed the way it showed users its games by showing newer games first, which led to new game developers gaining a bigger chunk of the market. To add to its problems, Draw Something has been losing popularity much faster than expected despite its initial success.
All of these events precipitated to a July 25, 2012 earnings announcement where it lowered its FY 2012 guidance. The company lowered its guidance to an adjusted EBITDA of $180 – $250 million and an EPS of $0.04 to $0.09. This meant the revenues previously guided at $1.47 billion was lowered to $1.15 billion. This led to the stock falling from $5 to $3.
Guidance Cut Further in October 2012
On October 4, 2012 Zynga announced preliminary Q3 results and lowered guidance for the full year 2012 even further. Now Zynga guided to adjusted EBITDA of $147 – $162 million for 2012. The company cited reduced expectations for certain games (such as The Ville) as well as delays in launching several new games. The guidance lead the stock to fall even further reaching a new low of $2.21 on October 5, 2012.
Recent Revision to Trefis Price Estimate
We recently revised the Trefis price estimate for Zynga from $6.15 to $3.30 based primarily on the following changes to our forecasts:
(1) Reduced ARPU Growth Outlook
Previously we were expecting average revenue per user (ARPU) for many of Zynga’s games to increase from about $0.31 in 2012 to about $0.45 by the end of our forecast period. However, ARPU growth seems to be around flat for the company for 2012 so far, and the company’s weaker revenue and EBITDA guidance in spite of the growth in users suggests anemic ARPU growth in the near term. Furthermore, we remain cautious about how ARPUs will fare over the long run as improvements in monetization may be offset by a rising mix of usage in low monetization markets outside of the U.S. Overall, we’ve reduced our ARPU forecasts in many cases to reflect slower growth and a long-term ARPU figure of about $0.33 by the end of our forecast period.
In the case of Texas HoldEm Poker ARPUs, we’ve reduced the long-term projected ARPU from about $1.80 to about $1.30.
(2) Lower Gross Margin Outlook
Consistent with the reduced revenue and our downward revision in overall Zynga revenues (resulting from the lower ARPU forecast), we’ve reduced our gross margin outlook for the company from about 73% to about 68% by the end of the Trefis forecast period. In comparison, we estimate 2012 adjusted gross margin to about 70%.
(3) SG&A and R&D Rising as a Percentage of Revenues
While we’ve slightly reduced the absolute amount of adjusted SG&A and R&D expenses we expect Zynga to have longer term, these expenses have risen as a percentage of revenues due to the reduction in revenue forecasts. Combined with the reduction in our gross margin outlook, this has led to compression of the implied long-term adjusted EBITDA margin.
(4) Acknowledging Higher Uncertainty of New Games
We’ve also increased the discount rate we associate with Zynga’s new and future games from 13% to 15%. We believe the higher discount rate better reflects the risks and uncertainties associated with launching new games. As demonstrated by the OMGPOP acquisition, launching or buying new games, even ones that are popular, is fraught with risk.
The four changes described above account for the bulk of the $2.85 reduction in the Trefis price estimate.
5 Things to Consider If You’re Thinking About Potential Zynga Upside
(1) Zynga Has About $2.10 of Cash Per Share (account for 80%+ of it’s value currently)
According to its SEC filings, it has cash and marketable securities net of debt worth of nearly $1.57 billion and has about 760 million shares outstanding, which gives us a per share value of about $2.10. This means nearly 80%+ of the stock’s value can be explained by the company’s cash on hand and all its games, trademarks, contracts, intellectual property and users are being currently valued at about 20% of the stock price. Unless you believe Zynga’s cash pile will be squandered on unsuccessful acquisitions or the company will be cash flow negative for significant periods of time, the high cash per share sets a potential floor for how much Zynga’s stock may fall.
(2) Success Dependent on New And Future Games
Zynga has been facing a lot of competition recently, but it still has the most number of users and has the best track record so far in terms of game success. With its foray into serious games with the acquisition of A Bit Lucky and extending into real money gaming with online gambling, we can expect these segments to provide some upside for its stock. The market currently values new and future games at near zero values due to high failure rates of new games. We currently estimate that new and future games account for about 25% of the $3.30 per share Trefis price estimate for Zynga’s stock.
(3) Mobile Gaming Opportunity
The company has traditionally generated a major portion of its revenues either through advertising or virtual transactions. In the last couple of quarters, it has been focusing on the rapidly growing mobile gaming space, and we expect its mobile bets to pay off going forward. It has already launched multiple games on major smartphone platforms and is in a position to leverage its existing user base to cross-market its new games and quickly gain enough momentum to reach the top of the app/game leader-boards of the respective app stores.
We expect the mobile gaming frenzy which is expected to be amplified by the rising global smartphone penetration to drive its user growth going forward, as it continues to launch new games to attract additional users. You can check out the impact of new user additions on its value using this chart:
Zynga – Nokia Deal
To leverage the huge feature phone user base, popular games such as Draw Something and Zynga Poker, will now be available on the Nokia (NOK) Asha Touch feature phones along with the rest of the Nokia Series 40 range. Nokia is still a top player in the feature phone range in emerging markets and hopes to extend this lead with touch-based feature phones. The games will be available on a freemium model with free play and the option to purchase in-game credits. These are the first of its games to make its way to Nokia feature devices and will potentially drive more people to its Asha devices. These games will be added to the games already available on Nokia’s Asha Touch devices from publishers like EA (EA), Gameloft, Rovio, NAMCO BANDAI. This deal is an extension of the Lumia deal to bring Draw Something and Words with Friends to the smartphone range. 
(4) Online Gambling Opportunity
To spearhead its gambling initiative, the company has hired a new COO, Maytal Ginzburg, who was most recently the senior VP of regulated markets at 888 Holdings, a U.K.-based online gambling operator. The social game maker needs to diversify its income streams and cannot depend on Facebook to drive its revenues and we expect real money gambling to be an important area of focus in the coming years.
Zynga is currently best positioned to enter the online-social gambling space, as its Texas HoldEm Poker is the most popular game in the casino genre. It has also launched a couple more casino themed games like Bingo and Slingo, and is on track to launch some other popular casino titles. It already has the technology and the infrastructure, and could launch real-money versions of these games quickly, once it is done with the paperwork.
You can check out the impact of any increase in its average revenue per user in casino themed games due to its foray into online gambling using this chart:
Online Gambling Lucrative
The online gambling market outside the U.S. is worth $32 billion and Zynga Poker is the world’s largest social poker game which attracts users despite the fact that there is no pay off. Hiring Maytal Ginzburg seems to be a move to tap the real money gaming market. The company recently begun lobbying in Washington and California and its best chance to succeed is if online gaming becomes legal in the U.S. 
The company will have to deal with competition from gaming incumbents such as Caesars Entertainment (CZR), which already operates online gambling services in Europe, and that bought social and mobile game maker Playtika. Bally Technologies (BYI) and International Game Technology (IGT) were granted online gaming licenses in the U.S. The licenses only allow the companies to provide systems and services to casinos and not yet to offer games online; however, it is a step closer to online gambling. Bally will now offer its iGaming platform to casinos and IGT, its poker product to operators. If it enters online gambling, it goes up against popular gaming providers and casino operators who have significant mind share with gamers and so it will be harder for it to gain a foothold in the market. (Zynga Doubles Down On Online Gaming, www.fool.com, Set 4, 2012)
(5) Zynga Platform Initiative
Earlier this year, it launched its own gaming platform and cloud infrastructure — the Zynga Platform — in a bid to reduce its dependence on Facebook and to generate additional revenue by hosting and marketing games by other developers. It has already started marketing games by other studios and could become the default cloud gaming platform, thanks to the scalability and immense marketing reach it offers, and become a potential goldmine for the company.
- Nokia Extends Zynga Deal, www.techcrunch.com, Aug 16, 2012
- Big Fish Raises Stakes With Real Money Gambling, www.techcrunch.com, Aug 16, 2012
Disclosure: No positions