Zynga: A Better Quarter, But Nowhere Near Good Enough

| About: Zynga (ZNGA)
This article is now exclusive for PRO subscribers.

Summary

Zynga's Q4 numbers are better, and the strength in Poker and Words With Friends is surprising and welcome.

But Dawn of Titans clearly isn't the hit some bulls were hoping for, and the stock isn't cheap.

I'll give credit where credit is due - but I'm far from turning bullish.

I've been critical of Zynga (NASDAQ:ZNGA) on this site for nearly four years now, so I'll give credit where credit is due: CEO Frank Gibeau has done well in his first year on the job. And as bearish as I've been on ZNGA stock for those four years, I do see some reason for modest optimism coming out of the company's fourth quarter report on Thursday.

All that said, I'm far from turning bullish on ZNGA. This remains a company that is functionally unprofitable; even with profits hitting a five-year high in 2016, Zynga's dilution still far outpaces its cash flow and earnings. With Dawn of Titans clearly not the hit that some bulls were hoping for, the company seems out of major catalysts that can drive shares higher. Zynga shares might look 'cheap' given a $2 handle, but a $1.4 billion enterprise value means investors still are valuing the business way too highly. And while Q4 looked better, it's nowhere close to supporting that valuation.

The Good News First

There was some good news in Q4. The company seems to have salvaged Zynga Poker, which looked like it was declining. New features boosted the game, particularly in Q4, with the game's mobile audience up 21% sequentially. Figures from the Q4 2016 and Q4 2015 earnings slides that detail the proportion of bookings by game suggest a 20% increase in bookings for the game in Q4 - a reversal from a decline through the first nine months (full year bookings rose just 1.3%).

Slots bookings increased 21% for the full year, meanwhile, though growth slowed y/y to under 6% in Q4. FarmVille games were nearly flat (-1%) in the quarter, another surprising performance after a multi-year negative trend. And other games bookings increased 60% in Q4, and 31% for the full year, driven largely by CSR2 and the fourth quarter launch of Dawn of Titans.

Overall, bookings increased 8% year over year for Zynga, the first year of any real growth since the company's heyday at the beginning of the decade. (Bookings did grow under 1% in 2015.) Users were flat year over year in Q4, but ABPU increased nicely, to $1.20, as conversion jumped to 2.2% from 1.7%.

Meanwhile, profit improved as well, with Adjusted EBITDA rising to $61 million adding back changes in deferred revenue. (Zynga had to change its calculation in response to SEC guidance on non-GAAP reporting earlier this year; adding back deferred revenue somewhat mitigates the mismatch between the timing of expense and revenue reporting.) That's a sharp increase from $17 million a year ago (again, as calculated under the old formula). Bookings growth helped, but Zynga also took a big chunk out of opex; non-GAAP operating expenses were down 3% in the quarter, and over 7% for the full year by my calculation.

Numbers aside, I also thought the commentary was a notable improvement from past quarters. Zynga maintains its insistence on shading the numbers (more on that in a moment), but Gibeau at least admitted on the Q4 conference call that DoT was "slower out of the gate in terms of chart position." The argument that Poker and Words with Friends are "forever franchises" struck me as intriguing, and a plan to retrench somewhat in 2017, building on the current portfolio, similarly wise. Overall, Zynga sounds more "grown up," for lack of a better term, than it has at any point in its existence as a public company. And, again, I think Gibeau deserves some credit on that front.

Yeah, But...

There still are a number of holes in the Zynga bull case. The company's own highlights, when properly understood, show some of those holes. Zynga led the Q4 release by pointing out that the quarter beat guidance and that the company generated $60 million in operating cash flow in 2016. But it's starting to look like Zynga sandbags that guidance, and the $60 million in OCF is swamped by $10 million in capex and $107 million in stock-based expense. Including dilution, Zynga's cash flow would be about -$57 million for the year, which still leaves the company $100 million-plus short of coming close to supporting the current enterprise value.

Similarly, the company's insistence on highlighting the shift to mobile is a bit disconcerting. The share of Zynga's user base coming from mobile isn't growing because the company has some massive success in that area; it's growing because a) the Facebook (NASDAQ:FB) platform business is collapsing and b) overall traffic is shifting from desktop to mobile.

That shift, as I've pointed out before, also inflates Zynga's bookings. Facebook takes 30% of consumer spend, but Zynga books those sales on a net basis. The roughly same percentage taken by Apple (NASDAQ:AAPL) or Google (NASDAQ:GOOG) (NASDAQ:GOOGL) is reported as revenue. By my calculations (which are imperfect, admittedly), increasing mobile penetration itself drove about half of the full-year bookings growth, both on an absolute basis and per user.

Meanwhile, the shift to mobile also may be impacting advertising bookings, which declined over 10% this year after being a key pillar of the argument for Zynga a year ago. That weakness leads to the major question here: really, what's left. Empires & Allies appears to be a flat-out best. DoT disappointed; CSR2 looks OK, but not a world-beater. Words with Friends and Poker might have longer-term potential, but neither can be counted on as a growth engine.

And in a bizarrely short conference call (just one analyst), Gibeau did say that the company would have "a handful" of new releases in 2017. But the focus seems to be on smaller games in existing categories; it appears there isn't another major release coming next year.

Zynga is getting full-year contributions from CSR2 and DoT, most notably this year. But a repeat of the 8% bookings growth this year, at current gross margin, still doesn't get Zynga's free cash flow above its stock-based expense - or imply positive Adjusted EBITDA by the same measure. Again, better isn't good enough, or close.

Valuation

Where there is some reason for optimism is that Zynga would appear to have a chance to massively change its operating structure. There's little evidence to suggest the company is planning to do so; headcount-related expense actually increased sequentially in Q4. And the company already has seen a series of layoffs; it may not have the stomach for more at the moment.

But the most obvious point of savings right now is R&D spend. That figure has come down steadily over the years: On a GAAP basis, the 2015 figure was almost exactly half that seen in 2011, and then declined another 11% in 2016. Yet Zynga still spent $320 million last year: some 42% of its bookings. For a company that is planning to roll out "a handful" of largely derivative releases, that figure seems massively inflated.

Modeling a continued reduction in that spend could, perhaps, get Zynga's profit and cash flows to a point where they support some sort of equity value. Another 50% reduction would add ~$160 million to EBITDA alone, and get the figure ex-dilution to $100 million-plus. Add in potential bookings growth to the point that other spend can be leveraged, and some additional real estate flexibility with a smaller workforce, and perhaps Zynga can become a legitimately profitable company that isn't just issuing stock to employees at a substantial discount.

But, again, even that path has some holes in it. For one, $100 million-plus in EBITDA ex-dilution still doesn't support even a $1 billion enterprise value, and thus a $2.25 share price. Bear in mind that Activision Blizzard (NASDAQ:ATVI) paid under 7x EBITDA for King Digital and Churchill Downs (NASDAQ:CHDN) paid 9.5x for Big Fish Games.

Secondly, that's still a multi-year plan, which requires that $2.25 price to be discounted back, putting current fair value closer to an even $2. And, third, Zynga hasn't really expressed much interest in that plan; the fact that Poker had a strong quarter after investment in new features may give Zynga reason to consider maintaining current opex levels.

The disconnect between expectations and reality for ZNGA long has quite literally baffled me. This is a company that has been functionally unprofitable from an EBITDA standpoint for five years now. The much-vaunted cash balance is down over $1 billion from where it stood at the end of 2011; yet the share count is 140 million shares higher than it was at the end of 2012 (the first full year after the IPO). That's about a billion and a half dollars in shareholder value destroyed over that period. The fact that 2016 saw less value destruction than years past is an improvement, but it's hardly a sign to turn bullish.

Still, 2016 is an improvement over past years, in a number of ways. Zynga does have some options, and it may be that a strategic decision not to rely on 'Hail Mary' hopes for a massive blockbuster game will change future decisions about opex spend and capital allocation. I'm not ready to bet on that type of sea change, particularly with Mark Pincus still the sole decider through Zynga's dual-class stock. But at the least, credit should be given where credit is due.

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

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.