Is a Zynga Recovery in Store?

Should investors view Zynga shares as an opportunity, or seek value in its peer King Digital? In

Jun 12, 2014 at 3:05PM

Zynga (NASDAQ:ZNGA) shares advanced 7% after UBS recently reiterated its "buy" rating, and investors ponder the likelihood of a recovery. Is it likely that a Zynga recovery is in sight, or should investors favor King Digital Entertainment (NYSE:KING) to become the next Activision Blizzard (NASDAQ:ATVI)?

Is this stability?
According to UBS, Zynga management remains focused on executing 2014 guidance, NaturalMotion integration, maximizing value, and increasing operating leverage. UBS has reiterated its "buy" rating and $6 price target, nearly double Zynga's current stock price.

While every analyst is entitled to his or her own opinion, UBS is painting a picture where everything's running smoothly, and assuming that management will meet all of their goals. In fact, UBS even said that it expects Zynga to be a beat-and-raise story, referring to earnings going forward. But in many ways, this positive outlook tends to argue against much of what the company has told us.

At a Bank of America conference last week, Zynga CEO Don Mattrick held a question-and-answer session that consequently caused shares to decline nearly 10%. In the conference, Mattrick said that the company's audience has stabilized, but at the same time he also warned of historically weak summer months ahead.

Another big announcement was that the company's employee count had fallen to 1,800. Keep in mind, Zynga had more than 2,600 prior to his tenure, and the company also incorporated NaturalMotion's staff. That means there have been some major cuts at the company, and combined with the possibility of a rough summer, that's not what most would call stable or flawless execution.

The always unpredictable
Zynga has lost about three-quarters of its valuation since its 2012 post-IPO stock highs, and new initiatives such as mobile games, like Farmville, have many believing that Zynga could be a turnaround stock. However, if we look at analysts' outlook, expectations are quite high already.

Specifically, analysts expect growth of 12% and 20% in 2014 and 2015, respectively, which essentially banks on stabilized daily and monthly active users along with the company capitalizing with another big-time game release in the next year, both of which are always unpredictable.

Where's the next Activision?
With two new game consoles in the last year, growing mobile gaming use, and expectations for new gaming platforms, it's no surprise that investors might see value in this space. However, Zynga might not be the best way to go.

King Digital is very much like Zynga in 2012, although the difference is that Candy Crush is much larger and more played than Farmville was at its peak. Yet, due to the rise and fall of Farmville, investors approach King with caution, which has resulted in a stock trading at 9 times earnings for a company that just grew first-quarter revenue by 195%, year over year.



King Daily Active Users

Source: King Digital

As you might expect, investors watch quarter-to-quarter performance as a way to spot trouble before it hits, which bodes well for King Digital. Specifically, Candy Crush as a percentage of total bookings did decline from 78% in the fourth quarter to 67% in the first quarter. However, King's total bookings increased nearly $10 million to $641.1 million, thus showing that its other games are growing in popularity; King has three games ranked in the top 10 on Apple AppStore and Google Play.

As you can see, King is not just a one-trick pony, but rather has three top games, and despite slowing user growth of Candy Crush, it has been able to combat losses with the growth of other games. For reference, Activision Blizzard is considered one of the top game companies in the world, with $4.3 billion in annual revenue, and expected growth of 8% this year.

Yet, despite its countless game titles, much of Activision's revenue is derived from two blockbuster franchises, Call of Duty and Skylanders, and the rise of a third, called Destiny. Therefore, for gaming stocks, it's typical for two or three games to drive fundamentals. This bodes well for cheap and undervalued King, a company that might not become the next Zynga, but rather the next Activision.

Final thoughts
With all things considered, Zynga shares are volatile for a reason, and that's because no one knows what to expect. So, what's the best way to play Zynga right now? The best answer is most likely to do nothing until the future becomes clearer. Instead, capitalize on the clear value of peers like King Digital, which seems to be operating a strategy for longevity.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.

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