Reviewing Earnings Reports at Caesars, Zynga, and Facebook

TAGs: Caesars Entertainment, Facebook, Gary Loveman, investing the hard way, Mark Pincus, Mark Zuckerberg, social games, Vince Martin, Zynga

Earnings season” is coming to an end, with companies reporting second quarter results to the market. Below is a recap of some key earnings reports that might be of interest to gambling investors:

Caesars Entertainment (CZR) 

Reviewing Earnings Reports at Caesars, Zynga, and FacebookI told you once, and then I told you again. Our esteemed boss Calvin Ayre told you as well, commenting on my July piece that “Caesars really is just an organisation that has evolved to be a debt servicing organisation…this company will eventually be taken over by their debt.” So we’ll say it one more time, just to be clear: Do not buy stock in Caesars Entertainment. After a manipulated IPO that a CNBC commentator called “the dumbest thing I’ve ever seen” led to a jump in the stock (from a $9 initial offering price), Caesars has gone nowhere but down. It fell further after announcing that it had lost $242 million in the second quarter, missing analyst estimates. The stock closed Friday at $8.15, below that $9 offering price and less than half of the $17.90 price the stock on its first day of trading. 

Caesars’ second quarter results leave little room for optimism that its share price will see any improvement in the near term, if at all. EBITDA (earnings before interest, taxes, depreciation, and amortization) fell year-over-year in nearly every region. And a quick review of Caesars’ financial statements shows the idiocy of the company reporting earnings before interest at all; interest expense for the first six months exceeded $1 billion, as the company’s nearly $20 billion debt load continues to choke off profits. Overall revenue grew just 0.2% year-over-year, with a slight decline domestically overcome by increased online and international traffic. 

In response to the revenue weakness, notably in Atlantic City, where the four Caesars properties saw revenue drop 8.6% year-over-year, Standard and Poor’s lowered its outlook on Caesars debt to “negative” from stable. As I noted two weeks ago, Caesars unsecured debt now yields over 20 percent, a fact Bloomberg picked up on just two days later. CreditSights analyst Chris Snow told the news service that “The issue is that this LBO is already four years old and is not doing that well for the sponsors…If trends continue to go against them, it could become obvious that they can’t compete in their existing markets.” And, indeed, the 20-percent-plus yields on Caesars bonds – meaning that  buyers are demanding interest payments equal to 20 percent of their investment annually – show that the bond market is factoring in a substantial chance that Caesars will go bankrupt.

In a conference call discussing the Q2 results, Caesars CEO Gary Loveman pointed to a “weakening U.S. economy” and complained that US online poker legalization had been stalled by a Congress that “is unable to act on anything.” But Loveman misses the point. He was at the helm when Caesars passed on Macau; and he was at the helm when the ludicrous, top-of-the-market, $22.5 billion leveraged buyout was agreed to in late 2007. Those two decisions have created the mess that is Caesars today: an over-leveraged company that does not – and cannot – create the revenue growth to overcome its massive interest expense. Loveman has no one to blame but himself, and neither does any investor who puts hard-earned cash into Caesars stock – or bonds.

Facebook (FB) and Zynga (ZNGA) 

Facebook and Zynga have been lumped in together as of late, which seems unfair to Facebook. After all, Facebook is a real company, not a purveyor of ripped-off, poorly designed, and glitchy ‘free’ games with no apparent capacity for long-term monetization. Indeed, Zynga plummeted some 40 percent after reporting disappointing Q2 earnings; even the company’s  announcement of plans for “real-money gaming” did nothing to help the stock rebound. Zynga closed Friday at $3, down sharply from its $10 IPO price in late 2011. 

I’ve bashed Zynga a few times, dismissing its real-money operations in April and calling it one of the market’s “five dumbest stocks” in May (when ZNGA was still above $8 per share). My opinion has changed little, even with the sharp decline. Analysts focused on the earnings report’s weaknesses, most notably Zynga cutting its guidance for full-year earnings from 23-29 cents per share to 4-9 cents per share. But many missed the key point: those earnings are non-GAAP, meaning they exclude certain charges, notably share-based compensation (ie, equity granted to employees.) That compensation, for the first six months of 2012, was $229 million, or more than one-third of revenue. Even by Silicon Valley standards, where option grants are a key method of compensation, that figure is staggering. 

Indeed, with Zynga already facing a class-action lawsuit for insider selling after the IPO, investors have to wonder: who is this company being run for, its shareholders – or its employees and executives? That is the key problem now with ZNGA because, by the numbers, the stock looks somewhat enticing at its current depressed prices. The company has fully $2 per share in cash and investments on its books, and revenues did grow 25 percent year-over-year in the first half, even if expenses rose at a higher rate. If the company can, indeed, create a viable, profitable poker platform, might it not be a steal at current levels? 

Maybe. But shareholders simply cannot trust CEO Mark Pincus or his company anymore. Yes, the company has $1.5 billion in cash; but it seems hell-bent on giving as much of that cash to employees and one-trick pony developers as possible. Yes, revenue is growing; but for how long can the company sustain sales growth – or even its current level of sales – if its revenue per user numbers continue to drop? 

At current levels, I would no longer recommending shorting Zynga; the cash balance and the potential for a huge pop based on a poker release or other piece of news make a short sale too risky. But there are thousands of stocks in the market, many of whom have great, sustainable, proven business models and shareholder-friendly management. Investors would be wise to find one of them, as opposed to becoming a shareholder in a company that has, in its short time as a public company, showed no respect for those very shareholders. 

As for Facebook, honestly, who knows? Ahead of its IPO, I wrote that “only a fool would buy Facebook stock,” and then suggested that Wall Street would likely find enough fools to keep the stock afloat. The fool was me, of course, as Facebook fell 20% in its first three days of trading. It hasn’t stopped, closing Friday at just over half of its IPO price. 

What appears to be the biggest issue facing Facebook – and its share price – is the company’s ability to adapt to the mobile space. According to Facebook’s 10-Q filing, mobile growth vastly outpaced user growth in the legacy desktop platform. “In all regions, an increasing number of our MAUs (monthly active users) are accessing Facebook through mobile devices,” the company wrote. In fact, mobile user growth rose 67%, compared to just 32% for users overall. The result, as the company noted, was that ad growth lagged user growth, as the number of ads per user on mobile is “substantially lower.” The company later noted that mobile usage impacted not only revenue growth from advertising but from gaming, another key revenue driver for Facebook. 

The problem for investors in Facebook is that it is very difficult to predict their potential success in the space simply because the company’s mobile initiatives are so new. As I noted in a piece for Seeking Alpha in May, Facebook’s first quarter 10-Q noted that the company’s mobile apps had not created “any meaningful revenue.” Facebook is making progress; on the Q2 conference call, CEO Mark Zuckerberg noted that Sponsored Stories ads on mobile were, by the end of June, creating a little over half a million a day in revenue. Unfortunately, for a company that is still valued at over $40 billion, a roughly $200 million annual revenue stream is hardly enough. And it’s not as if the mobile problem is easily solved; as I pointed out in the aforementioned article for Seeking Alpha, the increasing usage of smartphones has caused per-user revenue declines for other companies such as Groupon (GRPN), Pandora (P), and even search giant Google (GOOG). 

Beyond mobile, Facebook needs to expand its revenue base beyond advertising and payments from struggling Zynga. Real-money gambling has been offered as a panacea and indeed the company debuted its first real-money app last week. But again, Facebook’s history is limited here as well. Social gambling in Europe has hardly been a raging success; but, obviously, it hasn’t been tried by a company with Facebook’s literally global reach and dominant market position. 

For Facebook’s business, there is simply a tremendous amount of uncertainty that no investor, no matter how well-informed, can accurately gauge. And, in the short-term, there’s another issue: the expiration of so-called “lock-ups” following the company’s IPO. Certain sellers in the IPO are not allowed to sell additional shares on the open market for a predetermined amount of time, that period being known as the “lock-up.” Last week’s weakness was driven in part by the fact that an additional 60 percent of shares were made legally available for sale on Thursday. According to Bloomberg, Facebook’s 6.3% decline that day was the second-largest drop following a lock-up expiration since the beginning of 2011. Ironically, the largest drop was seen at Zynga, whose stock fell nearly 8% as insiders cashed out. 

This week’s expiration added 267 million shares to the company’s float, but as Bloomberg pointed out, an additional 1.6 billion shares will see their lock-up expire over the next nine months, with the majority being freed on November 14th. That is nearly triple the amount of shares currently available for trading. And that “overhang” of potential shares entering the market may keep the lid on Facebook’s share price. Without major movement at the company – early success in the iGaming sphere, an applauded strategy for mobile, or a third quarter earnings beat in October – Facebook stock should continue to flounder until the end of the year. Like Zynga, Facebook seems like a stock to stay away from, albeit for vastly different reasons. Though, unlike with Zynga, I’ve been wrong on Facebook before.


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