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The Remarkable Turnaround in ZNGA Stock Is Winding Up

Vince Martin

What’s interesting about Zynga (NASDAQ:ZNGA) over the past few years is that everyone got the stock wrong. That’s true from a broad standpoint: ZNGA stock has nearly tripled from early 2016 levels.

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But it’s also true looking more closely at both Zynga bulls and bears. When Zynga stock sat near $2, bulls pointed to the company’s huge cash balance, which at times cleared one billion dollars; its wholly-owned headquarters in San Francisco, which ostensibly could be sold; the Empires & Allies game; and its 2014 acquisition of NaturalMotion.

Bears (myself included, in the interest of full disclosure) saw Zynga Poker as doomed to follow the declines of older franchises like FarmVille and Mafia Wars, as the company adapted to declining game usage on the Facebook (NASDAQ:FB) platform.

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Bears obviously have been wrong on the games in particular: Zynga Poker remains the company’s top game, according to the 10-K. But the bull case hasn’t really played out, either.

While ZNGA backers were looking at the asset base, the company under former Electronic Arts (NASDAQ:EA) executive Frank Gibeau has ground out an impressive, old-fashioned turnaround. Empires & Allies has been discontinued, and NaturalMotion’s CSR2 has been decent but not spectacular. Cost controls, better execution, and smart capital allocation have driven earnings higher – and the Zynga stock price along with it.

Now, however, the turnaround is over, as even Zynga management wrote in the company’s Q4 shareholder letter. And the question becomes: what now?

ZNGA Stock Valuation

The case for ZNGA stock is that valuation is reasonable and growth is on the way. Valuation is a little tricky given that Zynga generates enormous amounts of deferred revenue that wind up being excluded from its profits. The company is guiding for an increase of some $200 million in deferred revenue in 2019: cash that will be brought in from player fees, but won’t be recognized as revenue until 2020 and beyond.

Still, it appears that ZNGA stock is reasonably valued. Guidance suggests bookings (reported revenue plus the change in deferred revenue) should rise some 39% in 2019. Margins are going to see some pressure, owing in part to upfront investments in research and development. But excluding the deferred revenue shift, adjusted EBITDA seems like it should come in around $250 million or so in 2019.

That’s a roughly 15-16x EV/EBITDA multiple which is high, but not terribly so in the context of the gaming space. Next year’s consensus EPS estimates of $0.26 suggest a roughly 20x multiple, backing out the company’s net cash.

Valuation obviously is quite different than it was a few years ago. In 2015-2016, the case for ZNGA stock was that value of the assets created a ‘floor’ under the stock. Now, investors are valuing the business at several billion dollars, which makes some sense.

The Case for Zynga Stock

After all, Zynga now has a base on diversified, stable franchises and growth opportunities arriving in the second half. The company claims five “forever” franchises: Words with Friends, Zynga Poker, CSR2, Merge Dragons!, and Empires & Puzzles. All five have held up well for years now and guidance suggests overall bookings for the group should grow in the first half.

With the turnaround complete, Zynga now is looking toward new efforts. Per the shareholder letter, new games are coming based on Game of Thrones, Harry Potter, and Star Wars. CityVille and FarmVille are getting new offerings as well.

The argument from bears for some time was that eventually, the “forever” franchises would crack. Zynga still generates around 20% of revenue from casino-type games and 15% from Zynga Poker. It seemed likely that at some point users would tire of those games but that hasn’t been the case. Overall slots bookings were up modestly in Q4 2018, and represented 21% of the total.

That performance has been echoed elsewhere: Caesars Entertainment (NASDAQ:CZR) sold its slot business at an attractive valuation. International Game Technology (NYSE:IGT) made a nice profit on Double Down Entertainment. Scientific Games (NASDAQ:SGMS) is spinning off a piece of its social gaming business to pay down debt.

Those social gaming assets (again, about 20% of bookings) clearly have value. The “forever” franchises have proven their worth. Advertising revenue is growing. And the new offerings should drive growth in the second half of 2019 into 2020. What’s not to like?

The Risks to Zynga Stock

There is good news here. But there are worries as well. Zynga Poker is slowing down, per commentary on the Q4 call and the 10-K. Words with Friends appears to be losing users. Zynga’s growth looks impressive – but a decent chunk of it has come from acquisitions, including the deal last year to buy the developer of Merge Dragons!.

Overall users are relatively flat even with help from acquisitions. Zynga is doing a better job of monetizing those players, including through higher advertising sales, but getting more money from the same amount of users is a difficult long-term goal.

As for the new games, the branded games will be less profitable, as Zynga will have to pay licensing fees. And the struggles of other developers like EA in doing justice to Star Wars are well-documented.

The bear take here is that Zynga really hasn’t been that good at developing games. It launched Zynga Poker a decade ago; the other four “forever franchises” all were acquired. Empires & Allies was a flop. (Empires & Puzzles was picked up through the acquisition of another developer, Small Giant Games.) In between, other than jumping on the social slots trend, Zynga hasn’t done much in-house. Now, it has to. Will it do it well?

The Bottom Line on ZNGA Stock

The other concern is on the valuation front. ZNGA stock is reasonably cheap if an investor excludes share-based compensation. That figure remains huge: some $68 million in 2018. That’s over 20% of profits. Exclude that dilution and Zynga stock is pricing in consistent growth for years to come.

Can Zynga drive that growth? Certainly. It’s done a nice job of late doing exactly that, but the improvement in recent years has come from acquisitions and improving already-developed games. Now, Zynga will have to take a different tack, and it will have to see a lot more success this time around for ZNGA stock to keep climbing.

As of this writing, Vince Martin is long shares of IGT. He has no positions in any other securities mentioned.

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