When a Stock is Roundly Hated, It’s Time to Check For an Upside

Could Farmville be a thing of the past? Some Facebook (FB) users already have taken steps to end their addiction to Zynga’s (ZNGA) iconic online game, taking a pledge to stop bombarding their Facebook friends with requests for farm animals and cyber-fertilizer. Nor, judging by Zynga’s earnings, has Farmville served as a kind of gateway drug for the company’s other online games. Indeed, the company’s financial statements have revealed that the revenue it is able to glean from each player of its online games – as they spend real money to buy cyber-gold that can be used to buy intangible merchandise for Farmville and other games – has fallen.

ZNGA Revenue Quarterly YoY Growth Chart

ZNGA Revenue Quarterly YoY Growth data by YCharts

In hopes of boosting its flagging financial results, including a severe slowing of revenue growth – Zynga posted a loss for its third quarter – the company now is venturing into “real” gambling. In October, the company said it would team up with Bwin.Party Digital Entertainment to offer online versions of real-money poker and casino-style games in Britain – generally a more receptive market for online gambling – beginning next year. Now Zynga has filed with Nevada’s gaming regulators, seeking a preliminary ruling that the company is a suitable candidate for offering online poker or other games. Getting that thumbs-up from the Nevada Gaming Control Board could take more than a year – and the process of getting an actual gaming license could take still longer. In the interim, is Zynga a stock to embrace based on this kind of long-term potential? Or is it now a value stock in its own right?

ZNGA Net Income Quarterly Chart

ZNGA Net Income Quarterly data by YCharts

If you’re thinking of taking a flyer on Zynga, it’s better to do it based on the latter hypothesis. Although its profits appear to have fallen off a cliff this year, its cash flow remains consistently above those earnings – a signal of acceptable earnings quality.

ZNGA R&D Expense Quarterly Chart

ZNGA R&D Expense Quarterly data by YCharts

One of the reasons for its bottom-line woes is the fact that the company has been investing in trying to develop new products, even though too few of those have made it out of the gate as yet. That kind of investment in future growth is a healthy signal for a young company, and could translate into future growth when the ideas generated are tested, proven and make their debut. It’s reasonable to question the ability of the company’s current management team to move innovation along as rapidly as needed to keep pace with the rate of change within the industry – the advent of mobile-based gaming, for instance, and the rapid rate at which users appear to tire of new games and begin to look for alternatives or for upgrades.

The biggest argument against owning Zynga – even in the wake of the stock’s massive price decline, which has taken it from its highs of nearly $15 a share in the first quarter to only $2.45 a share today – is the fact that it still commands a premium valuation. Given management missteps – overpaying for Draw Something, for instance, which began losing users at a rapid pace after being acquired by Zynga – it would be reasonable to question whether there might be some downside risk based just on management’s ability to execute.

ZNGA Cash and ST Investments  Chart

ZNGA Cash and ST Investments data by YCharts

On the other hand, the company still has a massive war chest stuffed with cash that it can put to use developing its online “real money” gambling plan or rolling out fresh innovations.

And let’s take another look at some of the bigger strategic issues, as well. Much of the focus on the change in the relationship between Facebook and Zynga (Zynga can now host its games on other platforms, while Facebook can develop its own games) has been on the opportunity it creates for Facebook; Zynga’s shares plunged 12% on the news. But to the extent that Zynga can execute on its plans – from new standard games, launching its games on new platforms, to the “real money” gaming plan over the longer term – Zynga could gain, too.

Investing in Zynga will remain – as it has been since its IPO – more than a bit of a gamble. But after the stock’s plunge, and with Zynga’s cash position, the odds for buyers of the stock have improved.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post.



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