Zynga: A Virtual Moat
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Fellow Fool writer Travis Hoium recently penned an article about several online stocks. He suggested these companies might have “fleeting competitive advantages at best”. With the likes of Pandora, Yelp, and Groupon, I mostly agreed with his logic. He cited the lack of a moat, and the fact that there didn't seem to be any stickiness to the users of these services. There was one company he lumped in with the rest that I disagreed with his logic, that company is Zynga (NASDAQ: ZNGA).
Travis' main problem with Zynga is, the company sells virtual stuff on virtual games. He worried that nothing is tying customers to these games. He also said, he didn't like that Zynga is tied to Facebook, which makes you share information. Finally, he mentioned if the company doesn't keep its games innovative, the stock will tumble. Let me take you through each of these issues piece by piece. I believe I can show you that Zynga actually does have a moat. In the world of online gaming, virtual stuff can lead to real world profits.
First, let's start with the numbers:
Current Price: $13.78
P/E on '12 earnings: 53
Growth expected: 24%
PEG: 2.21
Zynga is a relatively new company to the market, but in their last earnings release they did beat estimates by a comfortable 66%. This could indicate that estimates are too low. In fact, in the last 90 days, Zynga's 2012 estimates have been raised an average of 30%. It would be hard to say Zynga is cheap at 53 times earnings, but if their growth rate comes in closer to 30% - 40%, rather than 24% as expected, the stock isn't ridiculously overvalued.
According to the CAPS page for Zynga, the company has generated about $282 million in free cash flow in the last 4 quarters. This $282 million works out to about $0.11 per $1 of assets. For point of comparison, Electronic Arts (Nasdaq: EA) one of Zynga's competitors, actually shows negative cash flow in the last 4 quarters. A better comparison would be Activision Blizzard (NASDAQ: ATVI). Activision generated about $1.1 billion in free cash flow in the last 4 quarters. This $1.1 billion in free cash flow, indicates that the company is generating about $0.08 per $1 of assets in free cash flow. With Zynga generating more cash flow per dollar of assets, you can see one reason Zynga's stock is more highly valued.
Let's look at Travis' main problems one by one? The first was Zynga sells virtual stuff on virtual games. The main objective of free to play games is to hook you into the storyline, or to get you working towards a goal. Once this occurs, the virtual stuff starts to look more necessary. There are millions of gamers that begin these free games, and then get hooked. Once they play the game for a while, the idea of spending $0.99, or $1.99, or more is less of an issue. The point is, virtual stuff is important once you are invested in the game. This leads us to switching costs.
Travis says that switching costs are almost non-existent. That is simply not true. You get used to the layout of the game, the challenges, and the goals. In addition, if the gamer spends money even once, they won't likely abandon the game. I would suggest that once someone plays a game for about a month, the chance of switching drops dramatically. I know people who have played Farmville, and they have done so much, they wouldn't even consider abandoning all of that “work”.
The third issue Travis mentioned was Zynga is tied to Facebook. This is slightly less true at this point, as they have established Zynga.com. There are over 1.5 million people playing on this site right now. Facebook status updates about a Zynga game, gives the company free advertising. In addition, I've seen status updates where a person is playing a Zynga game, and they offer one of their friends something virtual to get them started. This is the best grassroots marketing, and there are millions of registered users of Facebook. I don't see this as a downside at all.
Travis' last issue was Zynga has to keep its games innovative. That is certainly a concern with any gaming company. With the spread of games from Farmville, to Cityville, Words with Friends, and others, it seems Zynga is doing fine branching out. That being said, Zynga is trying something that Amazon.com is famous for. With the new Zynga.com, the company is looking to be an aggregator of content. Zynga doesn't have to be the producer. Not everything you buy on Amazon.com is actually being sold by Amazon. In the same way, Zynga is looking for developers to bring their games to Zynga.com. If this happens on any large scale, Zynga won't have to rely on their own game creations, they can sit back and collect fees from licensing the games to their site.
Long story short, I think Zynga has found a niche in the online games market. The company is cash flow positive, and with Zynga.com the company has discovered a new growth opportunity. Their ties to Facebook give the company free advertising. While it would be hard to call Zynga's stock a bargain, the company is making all the right decisions. Casual games and virtual stuff are making Zynga real profits.
Motley Fool newsletter services recommend Activision Blizzard. The Motley Fool owns shares of Activision Blizzard. MHenage has no positions in the stocks mentioned above. 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.
