From The Motley Fool
In the final week of June, Zynga (NASDAQ: ZNGA) announced that another key member of the organization, Andy Tian, the head of its Beijing game studio, was leaving the company. As a result, shares dropped by nearly 7%, touching a five month low. But then, it announced the arrival of Don Mattrick and its stock rallied. The company is moving forward in its “year of transition” that now includes a leadership change, in addition to cost-cutting measures and the strategic shift from developing only casual games.
King of console gaming
In the beginning of July, Zynga revealed that its founder and CEO, Mark Pincus, is stepping aside. He will be replaced by Don Mattrick, an Electronic Arts (NASDAQ: EA) veteran and the head of Microsoft’s Xbox unit, who will steer the struggling game developer out of the crisis. Mark Pincus’s departure hasn’t surprised anyone, as he wasn’t shareholders' or employees' favorite. Moreover, the company’s performance, particularly the previous results reported in April when its sales plunged by 30%, expedited Pincus’s exit.
Meanwhile, Electronic Arts, or EA, which has risen by an astonishing 71% this year, is not looking so good. Its results are due out soon, and it doesn’t have a permanent CEO. The company, due to its habit of giving aggressive guidance, could very well post another earnings miss after twice missing estimates earlier this year. The industry as a whole is moving away from consoles, and although EA has made good progress in mobile and handheld devices, it still earns more than 80% of its revenue from console games. To make matters worse, the NCAA recently announced that it won’t renew its license with EA, which means that NCAA Football 2014 will be the final series title from EA. Its stock is trading at near 52-week highs, and with the earnings announcement approaching I would recommend staying away from Electronic Arts at the moment.
On the other hand, Zynga's new CEO, Mattrick, has transformed the Xbox into a console industry leader, is accredited with the impressive growth of Xbox Live, and is also the brains behind popular franchises such as Need for Speed, FIFA and The Sims. He has extensive experience in the three key areas: hardware, software, and networking. For Zynga, I believe this was a big step in the right direction after reporting a number of high profile departures. The news received shareholder’s approval, which was evident in the 10.4% rise in its stock on July 1.
But, why has Mattrick left Microsoft to take control of a struggling game developer? A flurry of articles on the internet have discussed this issue, but I believe there are two primary reasons for this. The first has to do with Microsoft’s current reorganization plans, in which Mattrick, despite his glittering achievements, couldn’t get a bigger role in the organization. This was reported by Fast Company in an interesting article about Mattrick. The second has to do with Zynga, which is seen as a “sinking ship” by some industry experts. As highlighted by tech analyst, Farhad Manjoo, if Mattrick is able to turn Zynga around, or even bring some stability to its top and bottom lines, then that would be the biggest accolade on his already impressive resume. If he fails, then he won’t be blamed as the ship was already sinking.
However, I'm more optimistic about Zynga’s future now than I was before. With Mattrick onboard, Zynga will move more swiftly toward mid-core games, mobile games, and real-money gaming, while retaining customers at Facebook (NASDAQ: FB). I believe that if there is one person who could do that, it's Don Mattrick. After all, he did a similar thing at Microsoft by adding millions of additional subscribers to Xbox Live without making compromises on the growth of Xbox.
However, with Facebook, my current cause of concern is the brain drain (which Zynga is all too familiar with), as some of its biggest and most experienced leaders are leaving the company for other opportunities. The latest one to go is 7-year veteran, North American sales chief Tom Arrix. The company earns less than half of its total revenue from North America. His exit comes after the departures of EMEA director, Christian Hernandez, the famed ad product chief, and the“Godfather” of Google’s Adsense, Gokul Rajaram, along with engineering director, Josh Wiseman. The company is now pushing toward increasing ad revenue, and it could introduce video ads as well as Instagram ads in the near future. However, it has to meet the delicate balance between enhancing revenue streams without disrupting the user experience. At current price levels, there is room for improvement, and I believe that the stock is going to cross $30 in the near future. But, there is no significant upside here, and the stock has lagged far behind the S&P-500, so I'd rather stay on the sidelines with Facebook.
Zynga’s shares have delivered a strong performance this year on the back of shareholder optimism, rising by 48.5%, easily outperforming Facebook, Microsoft, and the S&P-500 ETF (SPY), which are up 0.3%, 20%, and 21%, respectively, in the corresponding period. Zynga called 2013 its “year of transition” and with the new CEO, cost cutting initiatives (including laying off of 18% workers), new mobile-focused product launches, and mid-core and online gambling games, 2013 is proving just that.
Despite rising by more than 48% this year, Zynga is still not expensive. I haven't used price-to-earnings or PEG ratios because Zynga is still not making profits, therefore those ratios would not represent an accurate picture. Instead, I have relied on price-to-sales (P/S) and enterprise-value-to-sales to illustrate that Zynga is still cheap and has considerable room for growth. The stock is currently trading at 2.18 times its annual sales, which is close to Electronics Arts's number, as opposed to Facebook and Microsoft that are trading 11.4 times and 3.4 times their annual sales.
One advantage of using EV-to-sales ratio instead of the traditional price-to-earnings ratio is that the former incorporates the effects of cash and debt. Zynga has the lowest EV-to-sales ratio of the three firms shown in the table above, which illustrates that there could be more value for investors here than with other stocks.
Like any company in transition, Zynga has attracted its fair share of criticism (only some of which can be justified). For instance, the reduction in the role of Mark Pincus, despite retaining the role of Chairman and Chief Product Officer, is still a reduction and, therefore, should be viewed positively. Secondly, the hype surrounding the rise of King.com as Zynga’s biggest threat on Facebook is mostly hot air coming just before King.com’s IPO. Any in-depth analysis (such ashere) would reveal Zynga’s superiority over King.com. Investors should instead look at Zynga’s healthy balance sheet with $1.7 billion of cash reserves and no long-term debt. I believe that Zynga has a lot of potential and is moving in the right direction. In the coming months, it could easily outperform the market.
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Additional Disclosure: I, Sarfaraz A. Khan, have no position in any stocks mentioned and no plans to initiate any within the next 72 hours of this publication. I have no business relationship with any company mentioned in this article.