There's an old investing maxim that you can never fool the
same group of shareholders twice. Once burned, they simply ignore
#-ad_banner-#The only way to beat that problem is to find an
entirely new group of shareholders that may be unaware of your
More than two years ago, I cautioned that game seller
looked to be a flash in the pan
. Still, a few months after its IPO, hype and hope had pushed
Zynga's market value to above that of legendary toy maker
We knew that couldn't last. Indeed, shares of Zynga, which
soared into the teens, eventually plunged below $3. The
executives at Hasbro had nothing to worry about.
Well, a new group of investors believe they have discovered a
hot new growth stock. And they suggest Zynga is positioned to
become a long-term presence in the online gaming world.
History says otherwise. And this stock may soon start to move
back toward its multi-year lows.
Credit Where It's Due
To be sure, Zynga's new CEO, Don Mattrick, has stabilized
operations since he took the reins last summer. He's radically
cut costs, acknowledging that a game maker with only a few
popular titles did not need an army of game development
engineers. He also realized that the newest games the company was
developing weren't getting a lot of buzz.
How bad did things get? Sales plunged 31% in 2013, to $873
million, and the company has lost a combined $670 million in
The recent rebound in the stock isn't due to Mattrick's cost cuts
but instead to a pair of growth initiatives.
Zynga has been one of the hottest stocks of 2014,
but management will be hard-pressed to deliver the solid
growth that the share price seems to anticipate.
First, Zynga has recently made a stronger commitment to a
mobile strategy, helping to wean itself off an overwhelming
for its success. The launch of three popular titles in a mobile
earlier this month
was the catalyst for a fresh move to 52-week highs.
Yet some of Zynga's bulls say it is the January acquisition of
game maker NaturalMotion that will send this stock higher
(indeed, it already has). That firm has developed a reputation
for strong technology and a high level of creativity in the game
traits that Zynga was not noted for
Revving up the game development process is crucial as
once-popular titles such as "Farmville" and "Cityville" lose
momentum. The acquisition of NaturalMotion holds the promise of a
more robust game development team. Yet Zynga paid an awfully
stiff price ($525 million in cash and stock) for a company that
had $62 million in sales in 2013
The key takeaway: NaturalMotion didn't exactly have any
blockbusters on its hands either. Its "Clumsy Ninja" title, which
initially drew a lot of buzz, quickly fell out of the top 10.
Zynga projects that NaturalMotion's contribution to 2014 revenue
is unlikely to exceed $70 million or $80 million.
So what does this company looks like on a pro forma basis?
Sales are expected to grow around 10% this year, which means that
excluding the acquisition, the core Zynga business will be flat
Soon enough, Zynga will again be measured simply by its
ability to boost sales and generate profits. And this is where
deeper concerns arise.
For starters, investors shouldn't assume that the
NaturalMotion deal will reap a big payoff: "Zynga has not
provided a product plan, and employee turnover and acquisition
integration makes execution more (not less) difficult," note
analysts at Merrill Lynch, who rate shares as "underperform" with
a $3.80 price target. Consensus forecasts call for 15% revenue
growth in 2015 as the rebuilt development team delivers more
popular titles. But analysts are really only guessing.
Moreover, ZNGA has now become a very expensive stock. Analysts
expected to see 2014 earnings before interest, taxes,
depreciation and amortization (EBITDA) of around $220 million,
yet the current enterprise value stands at around $4.2 billion
(subtracting $391 million paid to NaturalMotion at the end of
January and assuming shares outstanding of 985 million). That
means shares trade for nearly 20 times projected 2015 EBITDA.
Such a lofty multiple is rarely justified and usually reserved
only for companies in the midst of sustained strong revenue
growth over multiple years.
Yet you can't apply that logic to game makers. Even if a
strong title or two gives them a sales boost in any given year,
such growth is rarely sustained. It's a fickle business with
erratic revenue streams, not worth a very high EBITDA
Said another way, shares of ZNGA are now worth more than four
times sales, but rivals such as
Electronic Arts (NYSE:
Take-Two Interactive (Nasdaq:
trade for around two times sales
This business is likely worth closer to 10 times projected
2015 EBITDA, or around $2.15 billion. Add in Zynga's pro forma
net cash of around $1.2 billion, and the target market value
would be around $3.3 billion to $3.4 billion. That works out to
be a share price just below $3.50. In coming quarters, as it
becomes apparent that the pricey acquisition is a help, but not a
game-changer, then shares will be hit by profit-taking.
Risks to Consider:
As an upside risk, Zynga and NaturalMotion could come up with
a blockbuster new title that forms the basis of a franchise, but
such hits are few and far between.
Action to Take -->
Zynga has been one of the hottest stocks of 2014, but management
will be hard-pressed to deliver the solid growth that the share
price seems to anticipate. The company will be delivering
first-quarter results and forward guidance in about a month, and
momentum investors may be quite disappointed. You can track the
current weekly sales trends for Zynga's games before the
first-quarter figures are released to get a sense of the
company's current games are maintaining or losing traction.
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