Why Zynga is Overvalued with or without Online Poker

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Let's be frank: Zynga's (NASDAQ: ZNGA) current batch of online gaming properties doesn't justify the company's current market cap. Zynga's gaming franchises are fun and even addicting (who hasn't played too much Words With Friends?) but from an investment standpoint they simply aren't compelling.

So that leaves us with the enterprise as it exists plus the Zynga Poker option. The company has net-net working capital of $750 million, implying that the actual value of the continuing operations and poker potential is worth $2 billion.

Does Zynga have a $2 billion opportunity in poker?

The company's big Zynga Poker franchise is the largest free-to-play poker game in the world with 38 million active users, but the app itself isn't a blockbuster, seeing as players use fake money to place their wagers.

Ascribing value to Zynga Poker isn't easy. It's best comparable is the old PokerStars, which did $1.4 billion in revenue and $500 million in net profit from 20 million players, or $25 in net profit per year per player. Zynga Poker has nearly twice as many members (38 million) as PokerStars, but not every free Zynga player will turn into a real money player.

I'm not one to shy away from back of the envelope math to determine a company's intrinsic value. I assume that PokerStars included ongoing marketing in sales, general and admin expenses, which reduced its net margin. Zynga Poker, having already established itself, should have much smaller SG&A expenses, so its profits per user will likely look much like PokerStars' revenues per user of $70.

Here's how I look at it

A 1% conversion rate from fake money to real money at the same per-user revenue as Poker Stars would generate $26.6 million in annual revenue. Thus, a 5% conversion rate would generate $133 million in annual revenue to Zynga, while a 10% conversion would result in $266 million in revenue to the company.

These figures are hardly worth getting excited about. Assuming even an extreme best case scenario where net margin is 100% from online poker revenue, Zynga looks tremendously overvalued. The “best case” is that Zynga Poker launches today, and generates $266 million in perpetuity, which, when discounted at a 10% discount rate, is only worth $2.6 billion, implying that Zynga is only modestly undervalued with extremely rosy assumptions.

Being only slightly more realistic about the launch time - not the profitability of each user - and assuming that Zynga Poker is still 5 years away from coming online in any meaningful form, poker as an option is worth only $1.6 billion when the cash flows are discounted for another 5 years of waiting time at the same 10% discount rate.

Those who expect Zynga Poker to contribute in a big way should moderate their expectations with a few simple realities:

  1. Zynga Poker players are not in any way guaranteed to become real money poker players, which is what the company needs to generate any profits worthy of attention.

  2. Legalization of online poker is still many years away, which discounts tremendously the value of future cash flows from a new, real money poker franchise.

  3. Zynga Poker players likely have old accounts at “pre-ban” real money poker sites, which will compete with Zynga for players if and when online poker is legalized. Caesar’s Entertainment (NASDAQ: CZR) and Boyd Gaming (NYSE: BYD), which operate Atlantic City, N.J.-based casinos are already planning to move into online poker after Gov. Chris Christie signed a bill legalizing it in the state. 

In short, those banking on poker to make or break Zynga's valuation should give it a second thought. In the best case scenario where Zynga converts 10% of its users to real money players, generates as much revenue per user as PokerStars, manages net profit margins of 100%, and launches today, the company is at best 20% undervalued.

If an investment is not meaningfully undervalued with pie-in-the-sky assumptions, it's not even worthy of speculation. Zynga is a loser for investors.

So what about gambling giants?

Zynga isn't the only way to play legalized online poker. Boyd Gaming is exposed to online gambling, however, the company's reports show that nearly 80% of its business is derived in traditional brick and mortar casinos, a highly capital-intensive segment of the gaming business. The company is the most exposed to recent changes in online poker legislation as it generates 36% of its revenue in Las Vegas, and another third in New Jersey.

Caesar's, unfortunately, isn't expected to generate any profits for some time to come. The company is bleeding in red in terms of earnings and cash flow, and shareholder's equity is negative once again, giving this company no real intrinsic value despite the company's exposure to New Jersey and Nevada, both of which are targets for legalized online poker. Caesar's looks like a much better candidate for bankruptcy than it does stellar stock market returns.

A play on poker, if there were one, would be a play on Boyd Gaming. However, unlike Zynga, Boyd Gaming has very expensive destination and casino properties that will negate most if not all of the gains seen in the digital space. Investors should wait it out. A new company without the legacy issues these three companies face will likely surface should online poker become a profitable endeavor.

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