Is Zynga Stock Still a Buy After a Disappointing Q3 2020?

Shares of mobile game developer Zynga (ZNGA) are down double-digit percentages following its third-quarter 2020 update earlier this month. Besides a general stay-at-home stock market sell-off after positive news on a COVID-19 vaccine, it seems growth during the summer months and the outlook for the final weeks of 2020 were disappointing -- especially considering the completion of two recent acquisitions. Zynga has been my favorite video game stock as of late so the share price decline certainly isn't what I was expecting, but I did buy for the long haul. The pullback thus looks like an opportunity to add a little more to my position.

Image source: Getty Images.

Don't fret too much over the numbers

To be fair, Zynga's Q3 report card wasn't all bad. Total revenue increased 46% year over year to $503 million, besting guidance provided a few months ago for revenue to be around $445 million. Net loss of $122 million was also much better than the forecasted net loss of $160 million. For reference, Zynga's previous outlook included results from the takeover of Peak, maker of mobile puzzle games Toy Blast and Toon Blast.

But where things started to get disappointing was on deferred revenue -- sales collected in advance for services yet to be rendered. Net year-over-year increase in deferred revenue was $125 million versus the $175 million expected. The reason had to do with the timing of collections and contracts from Peak. This seems to be bleeding over into the Q4 guidance as well. Revenue is expected to be $570 million, up "only" 41% from a year ago even though Toy Blast and Toon Blast are now in the fold. Another takeover, of hyper-casual mobile game maker Rollic (responsible for Go Knots 3D and Tangle Master 3D), was completed on Oct. 1 with initial contributions from newly released Harry Potter: Puzzles & Spells beginning during the holiday months. Net increase in deferred revenue is also expected to slow, to up just $100 million from the same period in 2019.

On the one hand, the pessimism is understandable given Zynga shelled out $1.8 billion for Peak and another $168 million for Rollic in recent months. However, big acquisitions like this can get messy, and it will take time for the full value of both new subsidiary game developers to be realized. Besides, even after its shopping spree, Zynga ended September with over $755 million in cash and short-term equivalents and convertible debt of $589 million. And though net losses are still being reported due to the recent spending, Zynga actually remains free cash flow positive (revenue less cash-only operating and capital expenses). Free cash flow was $108 million in the last quarter and totaled $296 million over the last trailing 12 months.

Remember the long-term potential

Zynga is undergoing long-term revitalization under CEO Frank Gibeau, with an emphasis being given to live game services and events. Increasing mobile engagement has worked so far, and adding new games (both those developed in-house and via acquisition) to the portfolio will be a winning strategy. After all, with Peak now part of the family, Zynga's mobile monthly average user count is 83 million, up 23% from last year. And adding both Peak and Rollic yields Zynga a new international audience it didn't have before. As expenses related to the acquisitions subside, there's plenty of room for the bottom line to increase too.  

Not to be discounted are some of the company's older games. In Q3, racing game CSR2, the perennial Words With Friends title, and the Social Slots and Casual Cards categories of games turned in record revenue for the period. Live events and new content releases aren't just prolonging life for these video games, they're helping them remain in growth mode long after their initial launch.  

This creates an asset-light game development company that has the potential to generate far higher profit margins down the road. Paired with Zynga's growth, shares still look like a reasonable value to me at 4.5 times current full-year expected sales and 27 times trailing 12-month free cash flow. I plan on making another purchase of this video game stock before 2020 draws to a close.