Contrary Call: Go Short Zynga Shares

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: John Pulliam
Title: Portfolio Manager
Firm: Vela Capital
Location: New York, NY

Undergrad: Wheaton College
Post Grad: Columbia Business School

Recommendation: Short Zynga (Nasdaq: ZNGA)
Timeframe: 3 Months to 6 Months
Price at Recommendation: $10.94
Price Target: $3.60

Quick Thesis
Last month, Zynga, the social gaming firm, purchased the latest fad in the social gaming sphere OMGPOP, for $200 million which represents 18% of Zynga's 2011 sales.

Based on recent trends, it appears that Zynga purchased the company at peak performance. Since the acquisition OMGPOP's primary game 'Draw Something' has fallen from number one to anywhere from second to twelfth on the iPhone and between sixth and eight on the iPad.

Because of acquisitions like OMGPOP, I like to think of Zynga as an oil company. It has a large collection of assets (games) that are either growing through new discovery or depleting due to use. Although as the OMGPOP acquisition shows, digital assets can deplete much more rapidly than an oil field.

Zynga made the OMGPOP acquisition because its core business has either stabilized or is in decline. For example, in the first quarter, daily active users were flat. And, OMGPOP's revenue per DAU is ~$0.01 versus Zynga's $0.06 so profitability is likely to suffer.

The typical path for a Zynga game is a buildup in daily active users over a 1-3 month period followed by a gradual decline. The reason for this dynamic is that video games regardless of the context become boring to the user after a period of time. Currently, the only thing keeping Zynga's DAU steady is recent launches. The older games are losing DAU at an accelerating pace. For example, games that are older than six months were -30% in Q1 of 2012 versus that the same category losing only 23% in Q3 of 2011.

To say Zynga is in a hit driven business is an understatement. As there clearly are no barriers to entry, I think it is accurate to describe almost a favorable downward ramp for competitors to enter the industry (the opposite of one of Porter's five forces).

Brief Valuation
Zynga is clearly in a very bad industry. Not only does it not have meaningful barriers to entry, its activities have made it easier for smaller competitors to enter. Yet, the company trades at 20x 2012 EV/EBITDA estimates. Companies in bad industries with stagnant growth typically trade between 3-6x EV/EBITDA. I will use the top to give the short seller a margin of safety (target of ~$3.60 and assumes the cash is needed inventory for rapid fire acquisitions but clearly that is a positive and part of the reason why I used a 6x and not a 4x or 5x).

Zynga also deserves a low EV/EBITDA multiple because it has a very high level of CAPEX. For the last three years, Zynga's CAPEX has been at 21% of sales (21% in 2011). Given it is very likely they will be required to make OMGPOP type acquisitions every few years (I will assume every three years although three years in the social media gaming space is like 15 years in a normal industry) their real CAPEX to sales ratio is 27%. EA (trading at 6x forward EV/EBITDA) averages only 4%. So as Warren Buffet likes to say, because the tooth fairy doesn't pay for CAPEX, it is a good idea to adjust EV/EBITDA multiples for CAPEX levels. But I will leave that in the margin of safety for the short seller. I personally would not buy this stock above $2 given the extreme operating volatility.

Conclusion
I can already hear the Zynga bulls screaming that the $3.60 price target is outrageous. Valuing a company with $150 million in free cash flow at $2.6 billion is actually generous and allows room for growth. It only appears to be outrageous in the context of a ridiculous social media bubble that investment banks are once again fueling (remember the 90s?) to maximize fees.

Companies in bad industries should get low multiples regardless of hype. Once the hype fades, the stock will fall towards fair value. Look at the chart for Pandora or Demand Media. Zynga will follow that pattern because the economics of its business are highly unattractive and its core business is no longer growing.

Disclosure: I am short Zynga.