AGILEVC My idle thoughts on tech startups

August 9, 2012

Draw something… other than this painful chart

Zynga’s faced a lot of pressure in the public markets recently.  The company’s lost nearly 80% of its value from the peak earlier this year, in the run up to Facebook’s IPO, and currently trades below $3/share… a fraction of it’s IPO price of $10.

That much we all know.  We also know lots of valid reasons why the company could be valued at far less than it once was including:

  1. Stalled Growth – revenue essentially flat over the last 4 quarters
  2. Governance/Control – Founder/CEO Mark Pincus has sold a good amount of his stock and owns <20% of shares outstanding, but now essentially has unilateral voting control of the company
  3. Mobile Monetization – as consumer usage shifts from browser/desktop casual games to mobile devices, opportunities for both virtual goods and ad revenue may decrease
  4. Significant CapEx - Zynga expects to have $380M in CapEx in 2012, though it’s worth noting that the vast majority of that is related to its new corporate headquarters which Zynga (e.g. one-time purchase offsetting future leasing expenses)
  5. IP Litigation – EA is suing Zynga for copyright infringement, and regardless of the merits this is a headache Zynga will have to deal with and pay to defend itself
  6. Management Shake-ups – most notably the sudden departure of COO John Schappert and shuffling of Marc Pincus’s direct reports

You can read about all of this stuff in Zynga’s own SEC filings or the popular press.  So I can appreciate why public stock investors would be leery of Zynga and why the stock price has been punished recently.  It’s hard to be bullish as a public market investor about a closely held company (in terms of control not ownership) that’s barely growing and faces strategic risks.

But at what point does Zynga become a value play?  Given Marc Pincus’s voting control, being acquired is presumably not in the cards for Zynga and a take private or LBO would be nearly unthinkable in the near term so there’s little chance of an M&A situation to arbitrage.  But at some point the valuation of the company puts it squarely into “value” stock territory rather than the heady “momentum” stock multiples Zynga once enjoyed, not that long ago.

The “value” case goes like this:

A) Valuation Net of Cash – Zynga’s market cap sits at around $2.2-2.3B as of this post.  But the company is sitting on a cash pile of over $1.6B.  Strictly speaking Zynga’s cash pile is split into three chunks according to GAAP rules… a bit over $400M is in cash & equivalents (e.g. money market funds, bank deposits, etc that can be converted into cash essentially instantly), about $800M is in short-term investments, and another $400M and change is in long-term investments.  All of these investments are held in high quality, highly liquid bonds issued or backed by the US Treasury and big corporations (see Zynga’s latest 10-Q).  The GAAP distinction is short-term investments are those bonds or instruments that mature more than 90 days but less than 1 year from now, long-term is anything over 1 yr maturity.

So theoretically if interest rates go up (aka duration risk) or the creditworthiness (aka credit spreads) of the US or the corporations Zynga owns bonds of changes dramatically, they could lose a small amount particularly on their long-term securities.  But practically speaking Zynga could turn all $1.6B+ of this into cash overnight if it really wanted to.  Tech companies which often have little or no debt of their own allocate their cash holdings in similar manner in order to prudently balance investment yield on these holdings… the vast majority of Apple’s $100B+ cash pile is held in long-term securities for exactly the same reason.

So the “value” case for Zynga has to start with the assumption that the business itself is worth more than $700-800M excluding its cash pile (i.e. $2.2-2.3B market cap minus $1.6B cash/investments).

B) Zynga’s Solidly Profitable – Yes, on a net income basis Zynga has been unprofitable the last 3 quarters though they did post net profit before they went public.  But if you dig deeper, Zynga looks to be a solidly profitable company by several measures.  Excluding non-cash expenses like stock compensation as well as revenue recognition timing (consumers pay it cash up front, but GAAP rules require them to recognize the revenue over time as virtual goods get “consumed”), Zynga generated over $150M in adjusted EBITDA during the first half of 2012.  Same is true when you look at actual cash in and out the door… Zynga’s operations generated $146M in positive cashflow in 1H 2012.

In other words, on an annualized basis the company is trading at something like 2.5-3.0x multiple (net of cash) of either adjusted EBITDA or operating cashflow.  Zynga’s trailing revenue is nearly $1.2B so its business (again net of cash) is valued at something like a 0.6-0.7x trailing revenue multiple.  That’s pretty darn cheap, no matter how  you slice it.

C) Zynga Has Decent Margins – Strictly speaking, Zynga’s gross margins are about 71% in the most recent quarter.  That’s their revenue minus cost of goods, and keep in mind Zynga’s top line already excludes the 30% take from Facebook (which still accounts for >90% of revenues).  71% gross margins are not exceptional for a software/internet company, but they’re not terrible either.  That being said, unlike a company that has essentially zero user acquisition costs (e.g. Facebook, LinkedIn, Yelp, etc) Zynga has to spend substantially on sales & marketing to acquire players.  But even if you back out customer acquisition spend in addition to COGS, Zynga’s profit margins are still over 50%.

 D) Casual Gaming Pioneer - Zynga still generates the majority of its revenue from US based players.  They pioneered free to play social games in the US 3-5 years ago, and have helped make mobile games a mass market phenomenon thanks to hits like Words With Friends and Draw Something (thru OMGPOP acquisition).  They face tons of competition in both realms and the shift from in casual gaming space from desktop/browser games to mobile presents challenges to Zynga and others.  But I personally still wouldn’t rule out Zynga’s potential to grow both parts of their business, as well as continued growth internationally.

E) Free/Cheap Option on Real-Money Gaming – There’s a growing belief that at some point in the next 5 years, restrictions on playing online games for real money in the US may be loosened, whether full out casino games or something just slightly beyond existing legal skill games (call it gambling “lite”).  It’s difficult to handicap these chances and I certainly wouldn’t invest in a company like Zynga for this reason alone.  But given Zynga’s first hit was in virtual poker, I feel a long investor in Zynga essentially gets a free option on the potential upside from more legalized forms of real-money gaming.  It still retains both a huge user base and strong internal DNA and technology to optimize online games, which IMO puts it in a stronger position than either physical gambling companies (e.g. Harrah’s, MGM, etc) or traditional video game companies in the even online gambling in some form becomes legal.

FWIW I have never had a position (long or short) in Zynga, and don’t intend to take a position in Zynga in the future… I already have ample personal exposure to consumer internet companies both public and private.  I also recognize the myriad of risks that a public investor might see in evaluating Zynga and structural reasons they might want to avoid being an investor (e.g. dual class governance w/ founder having majority voting control).  And given earnings misses and limited future guidance, Zynga’s relationship with public market investors has been a rocky one.  But at some point you have to say that there’s a valuation for Zynga’s profitable core business and cash pile which makes it a cheap value play on not just a comparative but an absolute basis.