When any stock falls 50% from its recent peak and then falls another 10% in a single session on very heavy volume, it's not usually because of some bad body language at a company presentation. The reason is usually much deeper and has a lot to do with the longer-term prospects of the company.
Body language was the causation, not the cause
Last Friday, Zynga (NASDAQ:ZNGA) plunged 10%, and that followed a 50% sell-off from its recent highs of about $6 a share. The explanation that most market observers gave was that during a question-and-answer session with an analyst at Bank of America Merrill Lynch's technology conference, Zynga CEO Don Mattrick was asked how he felt about his company's EBITDA, margins, and its mobile game business and answered, "We're nowhere near where we should be when we ultimately have executed."
In addition, when asked about the "two or three" winners that Zynga is expected to launch, Marttrick avoided talking about these so-called "winners," and instead talked about his long-term vision of the company and its great balance sheet.
When you promise winners and then you don't provide clarity, the market has every reason to believe that you don't have the goods. However, for a stock to fall as much as Zynga has recently, there have to be other reasons. And those reasons have to do with the question of when and if the company will ever gain traction, and when will it stop bleeding.
Zynga deserves a discount, but is trading at a premium
Given that we don't know when Zynga will finally gain traction in the social gaming space, and given that the CEO has not provided clarity about the company's profitability prospects, the stock should be trading at a discount. Instead, Zynga is trading -- even at these levels -- like a stock which is both growing and profitable.
Zynga's market cap currently stands at $2.7 billion and trades at about 3.4 times sales. For a company that has had falling revenue for several quarters now, it does not deserve to trade at such. BlackBerry, for example, also has a good balance sheet, but is trading at about one times forward sales. Apple, on the other hand, trades at 3.2 times trailing sales and is both highly profitable and with one-third its market cap in cash.
Obviously the price-to-sales ratio is not the only indicator we should look at. We should also take into account the balance sheet.
In Zynga's case, the company has about $2 billion in stockholder equity. Even if the company continues to lose money and revenue continues to fall, Zynga looks like a buy only once it is close to the shareholder equity level. There is no reason to pay a premium for a company with falling revenue and continued losses. But buying close to stockholders equity, you can at least buy some insurance against further downside, in the event that things don't work out.
If we divide the the market cap by the total shares outstanding, then to be on the safe side, investors who buy at $2.40 per share, should be well-protected against further deterioration of the company's balance sheet, revenue decline and long-term prospects.
Whether Zynga's shares will get that low we do not yet know. But until the company gets its act together and we get proof-positive data about its revenue and earnings potential, Zynga does not deserve to trade at 3.4 times sales and far above book value.