Facebook And Zynga: Partners In Gambling?

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In December we first talked about Zynga, Inc. (NASDAQ:ZNGA) being very undervalued and why investors should look to investing in the stock. In this article "Everybody Hates Zynga, Why You Should Love It," we detailed how undervalued Zynga was. At the time we felt the reason to buy the stock was simply based on its cash and the possibility of gambling. At the time ZNGA was trading at approximately $2.25. This week the stock hit $3.69 for a nice 50% move in a little over three months. Is the move done? Far from it and let's look at why!

Since the IPO, and actually before, there was much chatter about Facebook, Inc. (NASDAQ:FB) buying out ZNGA. After all, up until this past year, ZNGA was a major contributor to Facebook's bottom line. What we do not hear mentioned much is that the new poker site launched in the UK by Zynga will be powered by Facebook. The partnership with Bwin.Party Digital Entertainment will use the Facebook platform per the last earnings conference call. Facebook is looking outwards for its growth, as it can be argued the U.S. market is saturated now. Outside of the U.S., gambling is legal and a successful outcome of the Bwin/Zynga poker site using the Facebook platform could be the key for Facebook growing its revenue going forward. Such a tie up would also help greatly with garnering deals with land based casinos in the U.S.

Rumors of Facebook buying Zynga have calmed down greatly in recent months. If gambling takes off for Zynga in the UK in the coming months, and the push to legalize it here in the U.S. spreads, there could be strong reason for Facebook to swoop in and gobble up Zynga. Zynga still remains a large component of Facebook's revenues and this situation reminds us a lot of the eBay (NASDAQ:EBAY) and PayPal connection a few years ago. You may recall that when PayPal had its IPO, it too was a large component of eBay's revenues, which is why a year after the IPO eBay bought-out PayPal. A similar buyout by Facebook of Zynga would both cut costs and increase revenues for Facebook. These days PayPal is the major driver of eBay's profits. With gambling, Zynga could prove just as lucrative for Facebook. Even though Zynga's IPO price was $10 per share, an offer of $5-6 would likely win support from shareholders. At $5 per share Facebook could issue 150 million shares. Back out the $1.65 billion in cash and the offer would cost Facebook a little over $2 billion, not a bad price to pick up over one billion in additional revenues and huge potential with gambling.

From Zynga's recent earnings report, as of December 31, 2012, cash, cash equivalents and marketable securities were approximately $1.65 billion, compared to $1.65 billion as of September 30, 2012. Cash flow from operations was $19.8 million for the fourth quarter of 2012, compared to $164.0 million for the fourth quarter of 2011. Free cash flow was $29.5 million for the fourth quarter of 2012 compared to $101.9 million for the fourth quarter of 2011. As of Friday's close Zynga had a market cap of $2.65 billion, valuing its business at a mere $1 billion.

Since news of the Nevada and New Jersey poker pacts have hit the headlines, daily active users of Texas Hold'em has increased. Practice ahead of the real thing? The interest is there and it's Zynga's for the taking! A MAJOR positive that you also don't hear talked about much is the positive view Zynga has with users. It's trusted. If given an option of a new unknown poker company to gamble on OR the name brand, well known Zynga (or Facebook if they get wise and buy them out) is not something that can be measured in dollars but it is great.

Nevada signed into law its poker bill on February 21, and it lets land-based casino operators offer online poker only. New Jersey's law signed this past week lets existing operators offer all current games, but they must have their hardware located in Atlantic City. The rush is now on for these states to sign compacts with other states. The most lucrative of them all is of course California and New York. The bigger the state's population the bigger the revenue pie that will come. As states rush to fill tax and funding gaps, thanks to the dysfunction in DC and federal spending cuts, states find themselves needing more revenue. Nevada and New Jersey have started a race to approval in the states. Possible partners in these states could be the Indian Casinos that run most of the gambling in states outside of Nevada. It is our opinion that it won't be long until you see these smaller casinos make deals to get into the online gambling business. Even with the recent approvals it is expected to take some time for online gambling to truly roll-out in the U.S. On the recent earnings conference call, Zynga's CEO stated the following, "We've said that we have applied for an operator license in Nevada, and I think that process, we've heard, is 12 to 18 months," Pincus said when asked on the Feb. 25 call how soon the company could be offering its products in the U.S. The company applied for the suitability finding in December. In California, Zynga's home state, a bill sponsored by state Senator Roderick Wright limits online betting to Indian Casinos, card clubs and horse tracks, according to Arthur Terzakis, staff director of the Senate Standing Committee on Governmental Organization. This is another huge positive for Zynga as other states and Las Vegas casinos eye the California market.

Like December, the negative articles and comments on Zynga continue, and in some cases have increased. For investors, the longer a company is hated, as it rises in stock price, the better. It is usually when everyone starts to love a stock that the upgrades come, the lofty targets get spoken of, and that is typically when the top tends to be in. That appears to be far, far away still in Zynga. What we have heard lately from detractors is that the new laws in Nevada and New Jersey will favor homegrown casinos. Perhaps this is true but investors need to remember Zynga has an active client base of 38 million currently playing its poker games for free. No other free site, even the offerings by the casinos themselves, come even close to this. What is the more likely scenario is Zynga starts to partner with casinos to offer live gambling in the U.S. The early success in the UK will determine how quickly and how many casinos in the U.S. rush to make deals with Zynga. If Facebook is smart and wants to quickly drive revenue growth and cut costs, as well as gain a very early foothold into what could be a very lucrative market, now is the time to strike. Land based casinos would be quick to make partner deals with Facebook, although we would argue Zynga is in a similar enviable spot. By the September or December quarter we will have a very good idea of the success of Zynga's foray into legal gambling overseas. If it proves to be a hit, the post IPO highs seen last year will be quickly surpassed. That is if Facebook allows Zynga to remain independent. Zynga is up 50% this year, but the move higher to us only appears to be starting!

Disclosure: I am long ZNGA, FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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