Zynga, an unexpected value stock?

If you would have told me a year ago that I would consider investing in Zynga I would have declared you crazy. Valuation wise a lot has changed since then, and the company is actually close to becoming a net-net. On the balance sheet we find  $1.55B net in cash, cash equivalents and securities while Zynga has a $1.66B market capitalization. Not only does Zynga own a significant amount of cash, they also bought new headquarters this year that are worth a cool $272M. This basically means that you are getting the Zynga operating business for free these days. You don’t have to believe in a ‘the sky is the limit web 2.0-story’ anymore to consider an investment, but you do need to believe that it is a viable business.

To get an idea of the historic earnings power of the business I have created the table below with some key data of the performance of Zynga since the inception of the company.

Zynga has shown explosive revenue growth the past years, but seems to have hit a brick wall this year. Unfortunately the company never really managed to show impressive GAAP earnings with the exception of 2010. Fortunately for the company a lot of the expenses booked are non-cash items, and Adjusted EBITDA paints a different picture.

This absolutely doesn’t mean that we can conclude that Zynga has at it’s core a profitable business. One of the biggest costs that is excluded when looking at Adjusted EBITDA is stock based compensation, and this is a huge part of the pay that Zynga employees receive. If you need to pay a bunch of nerds to create games paying them $100,000 a year in cash or $100,000 in stock doesn’t make a huge difference: both costs are just as real, and if your stock drops big time you can bet that your programmers still want to receive roughly the same pay next year. So the GAAP numbers are a more or less reasonable approximation of Zynga’s profitability.

One thing where the GAAP numbers are a bit misleading is in my opinion with regards to revenue recognition. In a sense Zynga’s accounting is conservative: they don’t recognize income as soon as they sell virtual goods, but recognize the income over the duration of the lifetime of the item. I think the more aggressive approach would reflect reality better than the ‘conservative approach’. As soon as you have sold a customer some crap virtual item in Farmville you have the money in your pocket, and you don’t have to spend significant resources to deliver the service the customer paid for. Sure, you need to keep your servers online, but that’s just a small fraction of the cost of the good. Game development and advertising is where most of the money is disappearing.

Currently the delayed recognition of revenue is actually making the Zynga numbers look better than they are since bookings are down the last quarter, but earnings aren’t dropping as fast since they have deferred revenue from previous quarters. In the table above you can see how deferred revenue dropped from 480M at the end of 2011 to 390M right now.

Conclusion

From an asset point of view Zynga looks potentially interesting, and that is extremely rare for a software company since they are generally asset light. Unfortunately it seems to be questionable if the Zynga business model is sustainable. Looking at the historical earnings you get the idea that there are simply not enough paying customers for the average Zynga game to recoup the significant costs needed to create and run a game. And given the trend in revenues betting on growth and increasing economies of scale seems quite optimistic.

So Zynga is still not a stock I would invest in, but at the same time I wouldn’t be surprised if an investment at the current price would turn out favorable. The company has announced to cut 5% of their staff, rationalize their offering of online games and to buy back $200M of shares. If they manage to get their cost structure under control and not to do more stupid stuff with their cash like the disastrous OMGPOP acquisition it could work out alright.

Disclosure

None

8 thoughts on “Zynga, an unexpected value stock?

  1. LC

    I consider it a net-net that will burn through it’s remaining cash trying to develop (or buy) the next big internet game. The problem is that anyone can develop that game, whether it’s a 12-year old in his basement, another game developer, or Zynga themselves. And if Zynga doesn’t develop it internally (unlikely: most employees don’t seem to *like* working there, which I think will translate to the product they put out), then they will buy whoever does. Unfortunately Zynga has a poor record of acquisitions.

    The dark-horse is they apparently own some online-poker intellectual property which could pay off if the US ever legalizes online gambling. But that is a gamble future legislation.

    In either case, this is not a position I’m comfortable with.

    Reply
    1. Alpha Vulture Post author

      I agree with you, that’s why I looked at past profitability. A decent amount of the big web 2.0 names are actually pretty good businesses, but just too expensive for my taste. I have little doubt that FB or LNKD have a viable business model, unfortunately ZNGA falls in a different category.

      About the online poker opportunity: I’m an online poker player and I follow developments with regards to gambling legislation closely. I think it’s very likely that online gambling will be legalized in the US, but this is going to take time (years+) and IMO the value of Zynga Poker in such a scenario is highly uncertain. They will be facing some very strong competition: Pokerstars has almost a monopoly position these days, and the economics of the business are such that the biggest player has the best competitive position (for example: more liquidity for players and in a position to run the biggest tournaments). At the same time running a poker site isn’t a great business anymore: you need to spend a lot to attract new players and player churn is high.

      That said: they do have a lot of Zynga Poker users that could be converted in real money players at low cost, so positive developments with regards to gambling regulation would certainly be positive for Zynga.

      Some more interesting material w.r.t Zynga & Poker here.

      Reply
  2. pietje

    I don’t like to invest in a company that spends >200 million on a cool HQ after 5 years of non-profitable existence and after that has to cut 5% of their staff. Terrible capital allocation, not giving a shit about your shareholders and not giving a shit about your employees.

    And agree with the first comment: they will probably burn through all cash trying to develop the next hot videogame.

    Reply
    1. Alpha Vulture Post author

      What about “There are no bad businesses, just bad prices”? I agree that 2$/share still isn’t a compelling investment opportunity, but what about $1/share? 50 cents a share? Is there a price where you would be a buyer?

      Reply
      1. pietje

        Sure I would buy at some price and I admit that I haven’t defined that price clearly. But let’s compare Zynga to, for example, Solitron. Similar investments in the sense that both are business with a good balance sheet in a crappy business. Solitron has a cheaper valuation (balance-sheet wise), has been profitable for the past years and has shown no history of retarded capital allocation or stock-based compensation. Similar cases can be made for Argo group or for Asta Funding.

        Besides that, I really see no margin of safety in Zynga. They don’t give a shit about being a profitable company for shareholders. Valuations would have to shift quite a bit before I would consider switching any of these positions.

        Reply
        1. Alpha Vulture Post author

          You don’t have to convince me, there is a reason why I do own all those companies and not Zynga :). I’m saying that as this point in time it’s at least reasonable conceivable that an investment in Zynga could work out. That’s absolutely not the same as saying that it’s a value investment with a big margin of safety. It isn’t. But at the same time I don’t think Zynga is light years away from this point.

          Reply
          1. pietje

            I think I disagree on that. If you look at the balance sheet you see a big cash ‘cushion’ and some nice assets (most notably their HQ). But is that a margin of safety? From an operating point of view, Zynga is not profitable and they will probably rather go bankrupt trying to develop the next big hit rather than liquidating the company.

            So it’s not a conservative investment with a margin of safety, it’s a gamble on the company striking gold in the future and most of the time these bets do not work out. In a way it’s a lot like a biotech company.

  3. pietje

    It’s cheapish (but not as cheap as other stocks mentioned on their blog), but it doesn’t make a profit, doesn’t have a moat, revenue is stalling, I don’t believe in the business model and their accounting practices are dubious. I believe the great WEB would never invest in this.

    Reply

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