Wall Street consensus had been for Zynga Inc (NASDAQ:ZNGA), already suffering from a plunge in its stock price since its IPO in December 2011, to come in at zero cents per share in earnings for the third quarter. October 4th, however, was “take out the trash day” as the company made three negative announcements. The first was somewhat expected: the (cash!) acquisition of OMGPop, which appears to have come mere weeks before that company’s usership peaked, will be the target of a writedown in the neighborhood of $90 million. The second was the company’s expectation that earnings per share for the third quarter of 2012 would be in the range of zero to a loss of one cent (excluding the OMGPop charge). The third was most worrisome for Zynga followers: estimates of “bookings” (a metric Zynga which believes is more relevant than revenue) for the full year were cut by $100 million, with an expectation that Q3 bookings would be 16% below what the company did in the second quarter of the year. In other words, Zynga is not only at the borderline of profitability; it is currently a shrinking, not growing, business. The takeaway: it is now entirely possible that the best quarter in Zynga’s history will be the six cents per share that it earned in the first quarter of 2012- just three months after the company went public.
Zynga Inc has been battered by operational changes at Facebook Inc (NASDAQ:FB) which may have reduced traffic to its games (read our analysis of Zynga from summer 2012). At least for now, the sell-side expectation is that the company will recover somewhat and get to six cents per share in earnings next year, yielding a forward P/E of 26. We’re skeptical. Activity in Zynga’s games has been shown to be at best volatile and dependent on temporary highs from the introduction of new games (which means that the company must continue to generate new game ideas that are just as successful as its old ideas just to tread water), and at worst declining. Zynga has also seen considerable insider sales (see a history of insider sales at Zynga) though those aren’t particularly meaningful now as the stock price has fallen so far from where many of these insiders sold.
In the gaming space, we would compare Zynga Inc to Electronic Arts Inc. (NASDAQ:EA) and Activision Blizzard, Inc. (NASDAQ:ATVI) (see our previous article comparing EA to Zynga, Activision, and other peers). The video game industry as a whole has not been doing well recently, and it is showing in the case of these two market leaders: last quarter both saw declines in revenue and earnings compared to the same period in 2011. Activision’s share price is down 11% from a year ago, while EA’s has nearly been cut in half over the same time frame. Both trade at 11 times forward earnings estimates; in EA’s case much of these earnings are expected to come from a rebound in business, and Activision is expected to show substantial earnings growth next year as well. We don’t feel comfortable investing in either company.
Zynga can also be compared to Facebook and to Chinese online game company Changyou.com Limited (NASDAQ:CYOU). These companies’ valuations are very distinct from each other: Facebook trades at 76 times trailing earnings while Changyou’s P/E is only 5. We’d hesitate to call any Chinese company a great value at the moment, as occasionally these companies end up restating their earnings and questions are emerging about the macro economy in the country. Revenue and earnings did show double-digit growth in the company’s most recent quarter over a year earlier, however. Facebook is picking itself up off of its post-IPOs in the teens, currently trading above $21. Its forward multiple is still 35, so we would want to see a stronger indication that its ad sales can drive revenues much higher- or, for that matter, are even effective in the first place- before considering it as a growth stock.
Buying Zynga at this point is a risky move. The company’s profits are now about zero, and its sales appear to be down substantially compared to just three months ago. Its peers don’t look good either- unless an investor wants to take a chance on Changyou- but barring a strategic acquisition Zynga is greatly in need of a turnaround to even justify its current valuation.
