Investing The Hard Way: Will A Nevada License Save Struggling Zynga?
“Without the potential for real-money house games, Zynga is left with online poker, with a initial eye to the prospective US market. From there, all Zynga needs to become an online gambling powerhouse is to see poker legalization move at a faster pace than it has, or anyone thinks it will; completely overhaul its brand image and market to a demographic that has essentially no interest in its legacy games; complete a massive upgrade of its technical capabilities; and then outsmart competitors who have decades more experience in the gambling industry and partners who have already succeeded in the cutthroat European iGaming market.”
So I wrote back in April in dismissing Zynga’s (ZNGA) prospects for real-money gambling. Two weeks later, I called Zynga one of the “five dumbest stocks in the market,” noting “its clear emphasis on favoring employees and insiders over shareholders.” Zynga stock would go on to collapse, falling from a high of $15.91 in early March to $9 in April to Friday’s after-hours close of $2.57.
Of course, Friday’s close is actually up from recent lows – Zynga gained 10% in trading Thursday and Friday after announcing it was applying for an online poker license. And the percentage gain doesn’t show just how much optimism the Zynga announcement created. Bear in mind that Zynga’s market capitalization at the close of trading Wednesday, before the Nevada licensing news broke, was $1.744 billion. But Zynga, at the end of its third quarter, had $1.548 billion in cash and securities on its books, meaning its enterprise value – the value the market assigned to the actual operating business – was just $196 million. (All the more reason why the $500 million purchase of Double Down Interactive by International Game Technology (IGT) looks worse by the day.) At Friday’s after-hours close of $2.57, Zynga stock had risen 10%; but its enterprise value had risen to $392 million. In other words, the news of Zynga’s application in Nevada doubled the market’s estimate of the value of its operating business.
Of course, the Nevada application hasn’t been Zynga’s only move into real-money gambling; the company announced in October that it was partnering with bwin.Party Digital Entertainment (BPTY.L) for real-money gambling in the UK. That announcement, too, along with a decent third quarter earnings report, drove the stock higher, with ZNGA gaining 11 percent.
Zynga stock would soon give back those gains, and it seems likely that a similar retreat will come next week. For most of the year, online gambling announcements have created short-term gains for stocks, gains that are quickly reversed when the market realizes just how long and arduous the road to iGaming profits truly is.
In Zynga’s case, it seems especially likely that an impatient market will quickly forget about this week’s news. After all, as the company itself noted, the process in Nevada will take between 12 and 18 months. The company is well behind a number of more experienced operators; Bally Technologies (BYI) and International Game Technology (IGT) already received Nevada licenses in June, adding a head start of at least a year to their legacy advantages in game development and customer assessment. At least twelve other companies are considering applying for a license as well, raising serious questions of competition in a state with only 2.7 million people and, of course, a variety of land-based gambling options at their disposal. For iGaming companies, Nevada looks to be more of a test run for expansion to other, more populated locales than a market that has the potential to significantly impact a company’s bottom line.
Zynga’s UK joint venture with bwin.Party is similarly unlikely to make a short-term dent. According to figures provided by bwin.Party in their 2011 annual report, UK operations accounted for 10% of total revenue, roughly 82 million euros. However, much of that revenue came from bingo, as the UK accounted for 73% of the company’s total bingo win, thanks to market-leading Foxy Bingo. Non-bingo revenue in the UK in 2011 for bwin.Party was just 35 million euros; based on the breakdown of the company’s revenue worldwide, and the strength of sports betting in the UK, it seems likely that poker and casino products accounted for somewhere in the range of €15-20 million, or 20-25 million dollars for the company in 2011. Based on company-wide margins, it would appear that bwin.Party’s poker and casino segments in the UK – the same segments Zynga is joining through the joint venture – generated around $5 million, and no more than $10 million, in 2011 EBITDA (earnings before interest, taxes, depreciation, and amortization). As a point of comparison, Zynga is guiding for $152-$162 million in Adjusted EBITDA for 2012. For the UK move to increase that figure by even ten percent, the BPTY-Zynga joint venture would have to triple or quadruple bwin’s current UK segment profits. Further showing the limits of the UK venture is that the “adjusted” part of EBITDA requires the exclusion of stock-based compensation, which Zynga has projected will be $310-$325 million in 2012.
Math-proficient readers may have noted that the stock-based compensation figure for 2012 is expected to be double the company’s pre-tax earnings, yet another reason to stay away from Zynga stock. As I noted in October, CEO Mark Pincus and other Zynga executives – at least those that haven’t fled the sinking ship – have a remarkably poor record of corporate governance. In 2011 and 2012, at the low end of the company’s projections, Zynga will have given out $820 million combined in stock-based compensation to its employees, who are running a company right now valued at less than $400 million on an enterprise basis, with a stock that is down nearly 75% from its $10 per share IPO price less than a year ago. This is why the company, and its backers, are relying on real-money gambling; because its legacy business is, simply put, failing.
That’s not an exaggeration. Zynga games are losing popularity, and were hardly technical or design marvels to begin with. The exodus of executives has been called “a game of musical chairs” by tech news site AllThingsD, which argued the company is “plugging each hole” left by another defection “with talent from another part of the company.” Earnings are down, bookings are down, and so is the share price. Hence the “Hail Mary” pass toward RMG, but the arguments I made in April still stand. A company that has shown no technical expertise, that has no experience in the gambling sphere, and that has no evidence that social gamers are easily converted into real-money gamblers, is going to have a difficult, if not impossible, task to break into a cutthroat industry full of operators who have been successful for years. Neither a Nevada license nor the bwin.Party partnership will change that, at least not anytime soon.
Of course, the Zynga bulls argue that it’s just a matter of patience. Wait for the US to either expand gambling legalization through state-level processes or an overarching federal bill. Wait for success in the UK to lead Zynga to expand European partnerships. But what’s the point? You still have to own stock in a company that is not executing in its legacy market and is not treating its shareholders with even a modicum of respect. The long-term bull case may require waiting for gambling laws to be liberalized, but there’s more that patient investors must do: wait for the company to design better games; wait for the company to stop making disastrous acquisitions like the $180 million purchase of OMGPOP; and wait for executives to stop taking million-dollar payouts and then immediately leave tread marks in the parking lot of Zynga’s brand-new $228 million headquarters.
In a March interview, CEO Pincus told USA Today he wanted that Zynga-designed headquarters building to conjure up a “fantasy land.” In the section of the building where designers on the company’s “Farmville” game were working, he added that to create the proper ambiance, he wished “there was hay on the floor and live goats walking around.” It’s a shame Pincus didn’t ask for cows, too. A fantasy land filled with bullshit would be the perfect base of operations for his company.