This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Zynga could zoom!
In a call that seems destined to be called incredibly brave or incredibly dumb -- and perhaps even both -- Bank of America announced this morning that it's upgrading shares of social/mobile gamer Zynga (NASDAQ: ZNGA  ) .

And not just any upgrade, either. This is an upgrade coming just hours before Zynga reports its Q4 earnings (today, after market close). It's an upgrade that looks like the polar opposite of the cautious, reasonable downgrade that Northland Securities just assigned to rival gamer Glu Mobile (NASDAQ: GLUU  ) last week -- likewise ahead of an earnings report due out this evening. And it's an upgrade representing a 180-degree reversal of what B of A was saying about Zynga as recently as yesterday -- an upgrade all the way from underperform (that's "sell," to you and me) to buy.

So... what is it exactly about Zynga that has Bank of America not just going out on a limb, but scrambling on all fours, fast as it can, to rush right out there on the outermost twig and tell investors to buy Zynga before the news breaks?

Valuation matters
In a word, it's the valuation. Looking at Zynga today, Bank of America sees a stock that costs just $2.70 a share, but boasts $2.20 a share in cash and asset value. It sees a company collecting $200 million annually in revenue from its online poker business, and generating perhaps $200 million more from its mobile business.

Viewed from this perspective, therefore, once you strip out its assets, B of A sees Zynga as a $392 million business that generates easily $400 million or so in annual revenue. And that makes for a pretty enticing one-times-sales valuation on Zynga's business, as compared to the average gaming industry stock that costs 2.5 times sales. By way of comparison, gaming giant Activision Blizzard costs a whopping 2.9 times sales, while peer gamer Glu fetches 1.8 times sales. That latter number may be significant, given that Glu, like Zynga, is not currently making a profit.

On the other hand, though, giant Electronic Arts is earning a profit, yet it costs only 1.2 times sales -- a valuation all but indistinguishable from the one-times-sales valuation that Zynga carries (when viewed from the perspective B of A is taking).

Beware the caveats
The question, of course, is whether you really should be looking at this like B of A does? On the one hand, sure, B of A may know something we don't. They may have an inkling of some seriously good news that Zynga will report tonight, and so feel confident in spinning on a dime today and turning their sell rating into a buy. For instance, right in their report on Zynga, B of A notes that "mobile trends" are starting to look "more stable post-Q3 results," and that Zynga may beat Street estimates tonight -- resulting in more "downside risk" for shorts, than Zynga fans incur in hoping it will zoom to the upside.

On the other hand, though, I can't shake the suspicion that B of A is missing something important here.

I mean, yes, Zynga has a lot of cash and assets now. But it's burned through $36 million in negative free cash flow over the past year. How much cash will it have left after tonight's earnings update? And its assets -- a few servers, some work stations, some desks and chairs? This isn't a heavy equipment manufacturer, folks. These assets are going to depreciate fast.

Meanwhile, the company's relationship with Facebook (NASDAQ: FB  ) isn't as strong as it once was, endangering a revenue stream that Zynga's depended upon for most of its lifetime. (And speaking of which, if you think that Facebook looks overvalued at 2,868 times earnings, how much more overpriced is Zynga, at... infinity-times-the-profits-it-doesn't-earn)?

Foolish takeaway
When you get right down to it, valuing a profitless company on the revenue it's bringing in -- but not earning profits from -- seems to me a very circa-1999 way of thinking about investments. Sure, it's possible that Bank of America is right about Zynga, and that tonight's earnings report will wow the investing world, and renew investors' faith in a stock that's so far lost 81% of its value over the past year.

But if you ask me, the safer way to play tonight's earnings release is to refuse to play the earnings game at all. Why buy Zynga on a gamble about what it might announce tonight? Why not just wait for the numbers to come out, read them, and then make an informed decision on whether the stock is profitable enough to earn you a profit from buying it... or not?

That's the approach Northland took when hedging its bets on Gluu Mobile ahead of earnings last week. It's the approach I intend to take toward Zynga tonight as well.

Zynga's post-IPO performance has been dreadful, and investors are beginning to wonder if it's "game over" for this newly public company. Being so closely tied to the world's largest social network can be a blessing and a curse. You can learn everything you need to know about Zynga and whether it's a buy or a sell in our new premium research report. Don't even think about picking up shares before you read what our top analysts have to say about Zynga. Click here to access your copy.


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