Aggressive Zynga Is Better Than A Cash Rich One

Zynga Inc. (NASDAQ: ZNGA), like the broader video game sector, is doing well, enjoying a favorable demand environment. What is more exciting is that the company is finally stepping on the gas to execute a growth strategy that the company talked about forever.

Lockdown has fueled every video game company in the world, thanks to people staying indoors and sharpening their video game skills, and you could have picked any stock in the space; chances are you would have made money, but as we enter the ‘second leg’ of the rally, investors might be better off picking names that have some positive catalysts, besides the macro tailwinds.

So far, the Zynga stock has moved in tandem with the broader video games sector that includes not just the U.S. companies like Electronic Arts (NYSE: EA), Take-Two Interactive (Nasdaq: TTWO) and Activision Blizzard (Nasdaq: ATVI) but also the fast-growing Asian players like Sea Limited (NYSE: SE) and DouYu International (Nasdaq: DOYU), which we own and have covered in detail in another note.

But we believe there is more room to run here, as investors acknowledge the company’s superior execution, competitive positioning, and aggressive posturing in terms of driving growth.

Can the sector continue to attract investors? Yes

During the first-quarter conference call, one thing was common among all major U.S. video game companies – expecting things to ‘normalize’ by the second quarter and the forward guidance based on the said thesis that hasn’t happened yet, suggesting to us that guided numbers for the second quarter will be proven conservative.

Secondly, there are limited sectors that can offer growth in user base as well as engagement levels similar to those available in the video games sector, especially right now during the lockdown, so expect more and more retail investors to recognize that clubbing video game companies with the consumer technology names is a mistake, instead of valuing video games businesses as mainstream consumer entertainment or social networks may be more apt. Thus giving them a richer trading multiple, i.e. Netflix (Nasdaq: NFLX) and Facebook (Nasdaq: FB) type multiples.

Another major driver for the U.S. based video game publishers will be developments related to the next-generation video game consoles from Sony (NYSE: SNE) and Microsoft (Nasdaq: MSFT), which are expected at the end of this year.

Why Zynga, compared to other U.S. majors? Social and mobile

While other major U.S. based video game companies continue to be largely dependent upon video game consoles, Zynga has successfully built its franchise on the success of social and mobile gaming, trends that may last beyond lockdown. Indeed, Zynga’s recent acquisitions suggest the company is doubling down on the strategy.

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Purnha’s Source: Bloomberg

Electronic Arts is growing its services-based business with a decent pipeline of new content, but the company lacks a major mobile portfolio. Take-Two Interactive has done a great job moving towards annuity-based revenue, but revenue continues to be a problem, as highlighted by guided revenue decline for the year. Activision Blizzard will benefit from the expected ‘World of Warcraft’ expansion this year, but as a computer game, reliance on console and post-lockdown scenario will cap upside.

In the meantime, Zynga has a portfolio of popular games offered as live services that are free-to-play and accessible on mobile throughout the world.

Can Zynga continue with the current momentum? Yes

Zynga is delivering. During the first quarter, revenue grew 52% and bookings increased by 18%, with the best first quarter revenue and bookings in the company’s history. Guidance for the year, revenue growth of 25%, bookings increasing by 15%, and adjusted EBITDA of $210 million, was equally strong.

The big question is what will carry this momentum? We believe,

  • Near term: Conservative guidance
  • Medium-term: New titles, partnerships, and advertising revenues
  • Long-term: Unique combination of social and mobile

Near-term

The company’s guidance, though strong, assumed that ‘normalization’ will begin in the second quarter and did not assume the launch of any new titles in the second quarter. The economy remains far from ‘normalization’ and lockdown continues.

Live services are still strong and several new games are scheduled for launch over the next few weeks, both of which will support a strong user-pay growth. Second-quarter results may also highlight reactivations seen by the company, which will positively impact the all-important DAU metric.

Medium-term

New game titles, including games like Harry Potter: Puzzles & Spells, Puzzle Combat, and FarmVille 3 that entered soft launch in test markets during the first quarter, should help sustain the sales growth for the year.

There are rumors that the company will launch games for chat platforms like Zoom Video Communications (NYSE: ZM). Zynga’s developmental capabilities and a strong portfolio of games for social networks, like Snapchat (Nasdaq: SNAP) and Facebook Instant Games, positions it well to expand in the video-based social platforms.

Advertising revenue, though 20% of the total revenue base has suffered during the recent months, as the economy comes back, marketers are also expected to increase advertising on the platform, given impressions and engagement continues to grow nicely within the games.

Long-term

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Purnha’s Source: NewZoo

Longer-term, almost all major trends in the gaming industry – mobile, social and live services, are working in favor of Zynga. Yes, there are Asian and U.S. based private gaming companies that might monetize these trends more aggressively, among the U.S. based listed gaming companies, Zynga continues to be one of the best-positioned names.

Cash is mostly gone, but expect cash flow and profitability to improve

After the acquisition of Peak Games for $1.8 billion, the biggest acquisition in the company’s history, the safety net of cash is largely gone, which may not sit well with some of the value-oriented investors but improved profitability and cash flows over the next quarter may take care of those doubts.

With no debt and capital expenditure requirements of barely $25-30 million, the expected adjusted EBITDA of $210 million should be enough to offer comfort to the investors.

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