Here’s Why We Think Zynga’s Gross Margin Could Decline In The Future

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Zynga’s (NASDAQ:ZNGA) business has lost some of its sheen over the last few years due to several challenges, including a decline in its user base, a surge in losses, and an inability to come up with new hit games. Correspondingly, its gross margin has come down from 74% in 2012 to 70% in 2014. In this article, we analyze the key reasons why we think Zynga”s gross margin could trend downward going forward by assessing the various factors that affect gross margins.

The company’s cost of revenue includes data center and hosting expenses, consulting expenses pertaining to third-party customer support functions, payment processing and licensing fees, as well as headcount-related expenses (salaries, benefits, stock-based compensation) for customer support and infrastructure teams. We believe the key contributing factor to Zynga’s gross margin decrease in the future will be its ongoing shift towards the mobile platform, as mobile revenue is recognized on gross basis, as compared to Facebook-related revenues, where the revenue is recognized on net basis. Moreover, the continued decline in its Facebook business will further put pressure on margins. We think it is unlikely that Zynga’s business will re-accelerate in the short-term, and this could cause some operating de-leverage. The ongoing decline in its user base and the shut-down of web-based games will lead to a reduction in not only hosting and data center costs, but customer service expenses and headcount related expenses as well. Still, we think this may not be enough to offset the decline in gross margin.

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See our complete analysis for Zynga

Here Are The Key Issues That Will Cause Gross Margin To Decrease In The Future

Mobile Expansion Will Lead To Rise In Payment Processing Fees: Even though Zynga’s traditional web business is stumbling, its mobile business is showing promising results. Mobile bookings increased by 120% year over year and 14% quarter over quarter to comprise for 60% of the total bookings in the fourth quarter of 2014. Though web monthly active users (MAUs) dropped by around 59% annually in Q4 2014, mobile MAUs rose by 86% annually. This ongoing shift towards mobile is expected to add to gross margin pressure, as most of Zynga’s mobile revenue is recognized on gross basis, implying that the processing fee from companies such as Apple and Google is included in costs of goods sold.

Weakness In The Core Business: Zynga’s bookings and average monthly active user base fell by 3% and 31% during 2014, due to reduced usage of some of its older games and the failure to launch new hit games. The various challenges caused operating de-leverage leading to a drop in margins. We expect the short term outlook to stay grim for Zynga considering new games will only be launched starting the second half of the year. Hence, there is high likelihood that Zynga will continue to see revenue decline over the coming quarters, making it difficult to increase gross margins.

Decline In Facebook-Related Business: Zynga’s reliance on Facebook has reduced over the last few years, due the complex and evolving relationship between the two companies. This has negatively impacted the gross margin as Facebook-related revenue carries higher gross margin as compared to mobile revenues. This is because Zynga recognizes revenue net of the transaction fee retained by Facebook, which reduces the cost of goods sold. The share of Facebook in the company’s overall bookings has decreased from 69% in 2013 to 43% in 2014, and this proportion is further expected to come down in the future. Recently, Facebook introduced an advanced version of its developer platform and publishers are required to migrate to the new platform soon. Zynga will not migrate ten of its existing games to this new platform and hence, these games will be shut down.

Increase In Royalty Expenses: During 2014, Zynga partnered with major franchise and sports celebrities including the NFL, Tiger Woods and Warner Brothers’ Looney Toons to leverage their brands for launching new games in various categories including Sports and Runner. A marketing deal with the famous TV franchise ‘Real Housewives’ was also signed. We expect the licensing of IP to result in increased royalty expenses in the near future.

Here Are The Key Factors That Will Cause Gross Margin To Increase In The Future

As noted above, the factors that work to depress Zynga’s gross margin are likely to be partially offset by the impact of actions it is now taking to improve its business.  They include:

Reduction In Costs: The ongoing decline in the company’s business coupled with shut-down of web-based games will lead to decrease in hosting and data center costs, customer service expenses and headcount related expenses. Zynga reduced its headcount over the last two years, and in early 2014, cut around 15% of its workforce. We believe the company could continue to undertake such restructuring activities, if its top-line remains under-pressure in the coming years. This will weigh positively on the gross margin.

Consolidation Of Data Center Assets: Zynga closed down some of its offices and data center facilities in 2014, and consolidated its remaining data center operations. During 2014, a $38.1 million reduction in depreciation expense was recorded owing to the consolidation and disposition of data center assets. We expect these restructuring activities to result in continued savings in the coming future.

In a scenario wherein Zynga’s gross margin decreases to 60% in the long-run (as compared to our 66% estimate), then it will result in about 15% decrease in our price estimate. On the other hand, if this margin somehow increases to 74% due to significant turn-around in the business, then it would cause an increase of similar magnitude in our valuation for the company’s stock.

Our $2.30 price estimate for Zynga , implies a discount of about 15% to the current market price.

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