|Shares Out. (in M):||885||P/E||NM||NM|
|Market Cap (in $M):||2,866||P/FCF||NM||NM|
|Net Debt (in $M):||-1,137||EBIT||0||0|
|TEV (in $M):||1,729||TEV/EBIT||NM||NM|
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I am recommending a long position in Zynga stock (ZNGA) because it offers a very attractive, albeit binary, asymmetric risk reward opportunity. The company is in the midst of a management turnaround. After stumbling under the leadership of founder, Mark Pincus, Don Mattrick was brought in as CEO in July of 2013. The analyst community is very skeptical, having been severely disappointed in the recent past. Don Mattrick has a track record of success in the gaming industry and is highly incentivized with stock. The company has a lot of runway because it has a very strong balance sheet and is not burning cash.
At the current valuation, the market is assigning a very low probability of success to the turnaround. Wall Street analysts’ negative views are backward looking and are being influenced by a vacuum of information rather than specific incremental negative data points.
Although management has been unforthcoming with new information about the turnaround, there are some encouraging signs. Don Mattrick has made important changes to his management team. He has brought in employees with whom he worked in the past, including his COO and President of Studios. He completed the acquisition of Natural Motion which significantly enhances the Company’s technological capabilities. Furthermore, the company has had some recent success with adaptations of existing games into mobile formats, such as Farmville-Country Escape and has been able to stabilize its revenues.
Any success with new releases in the next six to twelve months could significantly shift the negative perception towards the stock and lead to a re-rating. If management is able to successfully turnaround the business, the stock could double or triple in the next two to three years. If management does not deliver any successful products in the next twelve months, there is probably 20-40% downside given that: 42% of the market capitalization is in cash; sentiment is already quite negative; revenues have stabilized; and, the company is not burning cash.
The mobile gaming industry is characterized by non-linearity, in which the top 10-20 grossing games garner the majority of profits. There are relatively low barriers to entry. However, as specifications for smart phones and tablets continue to advance, the graphical capability of the installed base allows for higher quality games. These higher quality games entail higher development costs, making it more difficult for single-team developers to create breakout hits. As the industry continues to mature, franchises will become increasingly more important.
Mobile games are projected to grow at a CAGR of 27% over the next 3 years. As the installed base of smart phones and tablets continues to grow, more free time and disposable income will shift to mobile usage. Asia is a key driver of this total growth. In China, 81% of people who connect to the internet do so via mobile devices.
People are playing games on tablets and smart phones more than any other activity. The games category outranks social media in terms of both reach (weekly users as % of users) and engagement (% of time spent) at approximately 60% and 65%, respectively.
Mark Pincus, a serial entrepreneur and former investment banker, started Zynga and exploited a loophole in the early Facebook Newsfeed which rapidly augmented the virality of Facebook games. Zynga employed a fast-follow strategy and imitated other successful games, counting on their vast reach to facilitate cross-promotion. Pincus serially acquired other smaller developers, often with single potential or realized hits. The headcount of the company ballooned. Facebook closed the Newsfeed loophole and instituted Facebook credits, taking 30% of game revenues, while Zynga’s user base began to expect more than low-quality fast-follow games. Zynga’s IPO in 2011 came shortly thereafter. Unable to create high-quality games, Zynga’s prospects rapidly declined. The company failed to successfully transition their largest franchise, FarmVille, to mobile, making the ensuing decline in revenues and collapse in the stock price inevitable.
About Don Mattrick, New CEO as of July 2013:
Don Mattrick, CEO – Mattrick started his first company, Distinctive Software, at age 17. This company eventually became Electronic Arts (EA) Canada when he sold it to EA 10 years later. At EA, he helped develop and scale franchises including The Sims, Need for Speed, and FIFA. After 15 years at EA, he joined Microsoft. Three years later he became President of the Interactive Entertainment Business and oversaw the growth of the XBOX Live player network from 6 to 50 million active members. Mattrick’s success being an entrepreneur, building franchises, and growing a player network uniquely prepares him for turning around ZNGA.
Mattrick is well-incented with stock:
Supporting Quotes on Don Mattrick:
“What’s going on inside Zynga right now is Mattrick is going to use the cash pile to rebuild the company as a mobile company from the ground up based on what my friends still at the company have said. This is feasible; Mattrick can do it. His reputation is based on his success now, so it’s not about the money.” – Co-founder of a mobile game studio and former Zynga employee
“Don refused to get caught up in the “here’s why this is going to be sub-par” and continued to drive for a ridiculously pure accountability to consumer delight and business results [at Microsoft]” – Microsoft employee under Mattrick
“Don is the guy to turn around Zynga; if anyone can do it he can.” –Director of Mobile Publishing at a major studio
“Don is a strong leader, he’s capable, and he wants the power of a CEO position. If anyone can do it [turn Zynga around], he can.” –President of a mobile game developer
“If he succeeds with Zynga, all the VCs will think of him as a golden child; if he can turn that around that will be a huge win in the valley and in the VC community; some doors will open up and he will be able to choose what he wants to do next.” – Microsoft employee who worked under Mattrick
The Natural Motion Acquisition:
A cornerstone of Don Mattrick’s strategy is the acquisition of NaturalMotion on Jan 30, 2014, for approximately $527 million ($391 million in cash and 39.8 million shares of ZNGA). NaturalMotion (NM) is a U.K.-based mobile game developer which was founded in 2001 by CEO Torsten Reil. It has approximately 260 employees. Torsten Reil leveraged his PhD research at Oxford into the development of the Euphoria game animation engine which has been used by AAA console game makers, including Rockstart Games on Grand Theft Auto IV and V, Read Dead Redemption, and Max Payne 3. NM’s Clumsy Ninja was the first mobile game to use Euphoria technology. Clumsy Ninja had over 10 million downloads in the first week and was announced during Apple’s iPhone 5 announcement. CSR Racing, NM’s other game, was one of the top grossing iPhone games of 2012 and has over 100 million downloads on Google Play and iOS
Supporting Quotes on NaturalMotion:
“It is really exciting to see the combination of these two great companies. I’ve known Zynga’s new CEO Don Mattrick since the late 90′s when he ran EA studios and I ran Activision studios, and he is one of the great executives in the video game business. NaturalMotion will provide Don with a fantastic slate of mobile products (both new, innovative ones, as well as sequels of their current hits). Combined with Zynga’s reach, social networking expertise, and advanced audience measurement tools, NaturalMotion and Zynga should be a very potent combination.” – Mitch Lasky, NaturalMotion board member and Partner at Benchmark Capital, an early investor in NaturalMotion, on Jan 30, 2014
“Reil [CEO of NaturalMotion] is a perfectionist, and he’ll delay games for months until the details are just right. That attention and care has attracted support from key partners like Apple, which let the company demo Clumsy Ninja and CSR Racing on-stage at the WWDC and iPhone 5 keynotes. (Let me just stress that being invited by Apple to go on-stage at their marquee events is like winning the “Best Picture” Oscar for an app developer.)” – TechCrunch, Jan 30, 2014
“So I'll kind of talk about the first time that I personally experienced [NaturalMotion’s] pipeline, making the transition from the console to the mobile space, and that was with the launch of CSR in 2012. And when I was at Microsoft, I had one of the studio heads come to me and say, ‘You've got to take a look at this. This is the first console-like product that we've seen on a tablet device.’” – Don Mattrick, Zynga CEO, Jan 30, 2014 Q4 2013 Earnings Call
“ ‘Visual virality’, that’s what we called it at NaturalMotion, where a game is so visually stunning that when someone plays it they go to their friends and say “hey you have to see this”. That is what Zynga bought, a set of people that know how to do that. Also, there are incredibly strong titles in the chamber that haven’t been released yet at NaturalMotion, if it’s like the way it was when I was there.” –former NM employee
“Turning to the cultural synergy, we will also be looking at opportunities to leverage NaturalMotion's proven blueprint for driving creative success with smaller, highly efficient teams. Culturally, they make decisions quickly and maintain a high-quality bar, resulting in game-changing products for consumers that benefit from word-of-mouth and high organic appeal. This is a model we are embracing and look forward to learning from.” – Clive Downie, COO, ZyngaQ4 2013 Earnings Call
Projections and Valuation:
These projections must be viewed with skepticism because they are not based on any visibility into Zynga’s pipeline. They are based on the assumption that Zynga is able to leverage its scale and vast development resources under a very capable and motivated leadership team. As Don Mattrick has stated, the success of this company will ultimately be driven by its ability to create games that people want to play and by its ability to build franchises around categories like Electronic Arts was able to do in console games. It is akin to a movie studio model.
The following projections assume a moderately successful turnaround. One must keep in mind that the social gaming category remains fragmented and is growing at an annual rate of 27%. My base case target of $6 per share assumes 12x my 2016 base case earnings estimate plus the cash per share (.39 x 12 = 4.68 + 1.29 = $5.97 per share). I am assuming a relatively low multiple given the historical volatility of this business. If, as the category matures, ZNGA is able to grow consistently and is able to create franchises around gaming categories, like the console game developers have been able to do, the company could experience a long period of revenue growth and the stock could benefit from multiple expansion.
If ZNGA does not deliver on any new hits in the next twelve months but continues to stabilize its business, I see downside to $2.00 per share. The $1.29 in cash per share plus other assets such as the real estate and Natural Motion, and the optionality of $850 million in revenues, I believe, will provide downside support around the $2 level.
Mobile gaming currently has relatively low barriers to entry (e.g. flappy bird) and customer captivity is generally short-lived, making the creation of a sustainable competitive advantage difficult.
The mobile gaming business is hit-driven, akin to the movie-making business in Hollywood: predicting the next blockbuster film (mobile game) is difficult just based on reading the script (description).
ZNGA is very late in making the platform transition to mobile, which created the opportunity for new entrants like Supercell, the creators of Hay Day, to create a farming-based game on mobile and supplant FarmVille. Successfully navigating the platform transition will be challenging given Zynga’s come-come-from-behind competitive positioning.
Don Mattrick is critical to the turnaround of Zynga. Mark Pincus, is still the largest shareholder and Chairman of the Board. Any conflict between Mr. Pincus and Mr. Mattrick would be detrimental to the turnaround. John Doerr, Kleiner Perkins partner and major shareholder joined the board as Lead Independent Director this month and is supportive of Mr. Mattrick.
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