Here’s Why We Changed Zynga’s Price Estimate To $2.30

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Zynga

We recently updated our price estimate for Zynga’s (NASDAQ:ZNGA) stock from $2.83 to $2.30, implying a change of around 20%. Our current valuation reflects ongoing challenges to the company’s business, including a decrease in user base, increasing losses, as well as a lack of new major game launches. Two key factors compelled this change in our valuation. First, we have reduced our revenue estimates over our forecast period, owing to the uncertainty surrounding the company’s business. Second, we believe that there is a grim outlook for profitability and accordingly have lowered EBITDA margin for the next few year.  This is because we think the company will have to incur high sales & marketing  and research & development expenses in the near-term as it seeks to rebuild its upcoming game pipeline.

Our $2.30 price estimate for Zynga, represents near-15% downside to the current market price.

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See our complete analysis for Zynga

Zynga’s Business Could Continue To Face Challenges In The Near-Term

Zynga’s top-line fell by 32% in 2013 and 21% in 2014 due to challenges in its Facebook and web games business, and due to reduced popularity of its older games. Taking into account the current uncertainty in Zynga’s business, we have decreased its long-term revenue estimate from $1.4 billion in our prior model to $1 billion in our updated price estimate. Here is the key rationale behind our estimates:

  • We think Zynga’s outlook could remain weak in the near-term, owing to the expected shutdown of several Facebook-related web games, and since many of the new games will only be launched during the second half of the year.
  • The company’s upcoming game pipeline consists of six to ten new games in evergreen gaming categories, including match-three puzzles, action-strategy and sports. New titles including FarmVille Harvest Swap, Empires & Allies and NaturalMotion’s Dawn of Titans will be released later this year. Since Zynga has limited experience in some of these newer gaming categories, we believe this adds to the uncertainty in the company’s future outlook.
  • Notwithstanding the current challenges, we forecast Zynga’s business to show some recovery in the long-run on the back of new games and strong growth on the mobile platform. We think some of the new games could help curb the decline in Zynga’s player base, leading to stabilization in monthly active users for Zynga’s games (excluding Poker) over the long-run. We expect Zynga’s mobile business to show continued growth over our forecast period. Mobile bookings grew 120% year over year and 14% quarter over quarter in Q4 2014   to account for 60% of overall bookings. In addition, the web business could stabilize over our forecast period owing to renewed focus on remaining web games and the transition of certain successful mobile games onto the PC platform.

If in fact our assumptions are too conservative, there will be upside to our lowered price estimate.  If Zynga is able to launch new hit games and its revenue reaches $1.5 billion by the end of our forecast period, then our model will produce a more than 25% increase in our price estimate to $3.00.

Zynga Could Face Profitability Pressure In The Near-Term

Zynga’s adjusted EBITDA margin has fallen drastically from 26% in 2012 to -5% in 2014 (as per our estimates). We expect the company to continue to face profitability pressure over the next few years, before the business shows some recovery in the long-term. The key factors driving these forecasts include:

  • Zynga’s gross margin could see some decline over the next few years due to rapid expansion on mobile platform, where cost of revenues are higher as the revenue is recognized on gross basis. In addition, the ongoing drop in Facebook-related revenues and increase in royalty expenses will continue to weigh on gross margins. This will partially be offset by cost savings resulting from consolidation of data centers and facilities, as well as reduced requirement for hosting and third-party customer service facilities. (See: Here’s Why We Think Zynga’s Gross Margin Could Decline In The Future)
  • In addition, sales & marketing, and research & development expenses as a % of revenue could stay high in the short-term, as the company would invest heavily on new games to boost its long-term outlook.
  • However, over the long-term, we expect Zynga’s EBITDA margins to expand as recovery in top-line could lead to some operating leverage gain in the future.

In a scenario where Zynga’s business continues to struggle and its EBITDA margin rises to only 15% by 2021, then it would represent over 15% decline in our price estimate. On the other hand, if Zynga is able to increase its EBITDA margin to 35% by the end of our forecast horizon, then it would result in more than 20% rise in our stock price.

We forecast Zynga’s capital expenditure as a percentage of revenue at around 3% over the long-run due to investments in software and hardware to sustain business operations. The company’s business is not capital intensive and this will most-likely limit growth in capex over our forecast period. Finally, we have pegged the discount rate at 13.0% for Zynga in our valuation model. We encourage our readers to modify our estimates, to see the impact on the company’s price estimate.

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