You Should Have Dumped Zynga Before Valentine's Day

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Breaking it off with a loved one on the eve of the most romantic holiday of the year can be heartbreaking, almost cruel. Zynga (Nasdaq: ZNGA  ) had high hopes of being investors' valentine with its first earnings release as a public company last night. Shares had rallied to all-time intraday highs of $14.55 yesterday on those same hopes, a whopping 37% jump since Facebook laid out the extent of their relationship.

The morning after
Shares have sold off by as much as 16% as of this writing, as the dreadful feeling of morning-after remorse sinks in after investors are now sobering up from the Facebook-driven euphoria. How bad could the digits be?

Revenue soared by 59% to $311.2 million in the fourth quarter, topping the market's expectations. Working our way to the bottom, Zynga's GAAP net loss was a monstrous $435 million, compared with the $43 million profit last time around. A huge chunk of that was related to $510 million in stock-based compensation expenses for restricted stock that hadn't been recognized until the IPO.

On a non-GAAP basis, net income shrank 41% to $37.2 million, or a nickel per share. Bookings rose 26% to $306.5 million, while adjusted EBITDA fell 34% to $67.8 million.

Looking at the full year, revenue jumped 91% to $1.14 billion, while generating a GAAP net loss of $404.3 million, including the aforementioned stock-based compensation. That comes out to a loss of $1.40 per share. From a non-GAAP perspective, earnings per share dropped from $0.38 to $0.24.

Are you engaged?
Zynga tracks its user base in a few different ways -- daily active users (DAUs), monthly active users (MAUs), monthly unique users (MUUs), and average daily bookings per daily active user (ABPU). Looking at these figures, the trends appear reasonably healthy on the surface.

Source: SEC filings.

Source: SEC filings.

With no glaring dropoffs and increasing ABPU, especially in the context of no blockbuster game releases, why are investors so disappointed with Zynga's digits?

Zynga to investors: "It's not you, it's me"
Two words: growth and valuation. The social-game maker is trading at astronomical valuations right now of 164 times earnings. That's a massively premium valuation, partially spawned from all the Facebook hype, that needs to be justified by similarly sky-high growth. This is where the story starts to unravel, as Zynga's revenue and bookings growth have been plummeting on a sequential basis.

Source: SEC filings.

Source: SEC filings.

While it's entirely natural and expected for any up-and-coming growth stock to show some signs of slowing growth as they grow their revenue base, it's also entirely natural and expected for short-sighted investors to bid up one of the most overhyped IPOs in recent months in the face of the mother of all hyped-up IPOs for a related company in the pipeline.

Bookings represent the total revenue that is brought in from the sale of virtual goods and is a proxy for what Zynga would see as revenue if it was all recognized immediately at the time of sale. Instead, revenue is deferred and recognized over the life of those virtual goods as they're consumed, so bookings are an incredibly important precursor to revenue.

You'll notice in that previous chart that revenue was starting to catch up with bookings as it was recognized, and revenue recently outpaced bookings in dollar terms, casting doubts on how much Zynga's top line can keep growing.

Zynga's recent rally was hardly justified, and shares had reached unsustainable premiums, so it's hardly a shocker when the prospects of slowing growth question the company's ability to monetize its user base.

Maybe a trial separation would be good for us
I still think Zynga has even more downside from here, because of its still-sky-high valuation and shrinking growth prospects. The company's market cap is about $8.5 billion right now, higher than game stalwart Electronic Arts (Nasdaq: EA  ) at $5.9 billion, a game maker that's been around for nearly three decades and has much greater brand strength with its franchises.

Fellow freemium social-game maker Glu Mobile (Nasdaq: GLUU  ) is also on my bad side, since I don't think it's a sustainable business model for the industry. Glu is also seeing a separation from reality.

I'll give Zynga one potentially major growth catalyst: the possible legalization of online gaming (the gambling type). Zynga Poker is incredibly popular on iOS, and the prospect of converting all those players into real cash cows could be juicy. That said, if online gaming is legalized, there would be a gold rush of companies wanting to cash in, including capable gaming heavyweights like Wynn Resorts (Nasdaq: WYNN  ) and MGM (NYSE: MGM  ) , both of which have already been looking for potential partnerships if the light turns green. It's an interesting possibility, but one that's too far away and uncertain to start banking on.

As it stands, Zynga is better off as a one-night stand instead of one to settle down with. Considering that we Fools are typically in for the long haul, Zynga will never be my valentine.

Zynga is decidedly not a Rule Breaker with multibagger potential -- it just likes to pretend that it is, which makes it only a Faker Breaker. If you really want to discover the next rule-breaking multibagger, ignore Zynga and check out our special new free report. There are six signs of a true Rule Breaker, and this company scores on all six. I've even already bought it in my own personal portfolio. Get your free copy of this report now to see why it might fit in yours.

Fool contributor Evan Niu holds no position in any company mentioned. Check out his holdings and a short bio. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (5)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 16, 2012, at 10:56 AM, cp757 wrote:

    The gambling pie in the US is about 90 billion and I think can be cut up anyway you want but Internet Gambling is not a sure winner like everyone thinks. Every casino, corner bar ,and seven eleven will want to start on line poker outlets . I know if I could get one of twenty five license's you could sign me up. I would probably sign up if they offered 5000, but I think the law of diminishing returns kicks in at some point. As you say in the story Zynga is talking about online revenue but what about the other social-game makers. Double Down Interactive was purchased by (IGT) because of its value with Facebook. Would Activision Blizzard Inc (ATVI) have a chance at this market ?They have millions of players and they know how to create an experience that is interactive and interesting to the player. Light years ahead of Gambling company's that want to enter the market.We all know MGM ,WYNN,andCZR are all saying they want in. Can anyone in the United States think of a reason you would exclude the American Indian Tribes.The Tribes will not be kept from getting licenses for online gambling and they have about 400 casinos. A company in Japan has a tie in with gambling they sell lottery tickets to us and would love to get in on online gambling.They have 39,000 locations and are close to our homes. Seven-Eleven Japan Co. Ltd is the company in the U.S. with an advantage to do tie ins with there stores if they had an online gambling site. Online Gambling will take part or the gambling pie. It might even add to the pie, but in the end the online gambling pie will be cut up into small pieces.

  • Report this Comment On February 17, 2012, at 5:42 AM, steveat wrote:

    with gambling, the house always wins and I believe they will receive some real nice revenues by converting play money to real money at some point.

    There are a lot of FB users that hate those stupid Zynga games..I know I do, but hey, it works for them. I like their poker game though and if they start adding more skilled games, plus even sports betting, that would be very attractive.

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