Zynga (NASDAQ:ZNGA) has on been fire in 2019. Zynga stock has risen more than 55% year-to-date as the company’s mobile revenue transition has gained considerable momentum in 2019.
Specifically, the company has reported a series of record-setting quarters in 2019, the sum of which shows that this company has successfully turned its no-growth mobile business, into a big-growth mobile business.
Investors have bought into the hype that Zynga is turning into a profitable and big-growth mobile gaming giant. Zynga stock has consequently soared to its highest levels since 2012.
Despite the operational momentum, I’m not sold on Zynga on the heels of its big 2019 rally to record highs. Instead, I think caution is warranted here, especially given that Zynga’s big revenue growth this year has not been accompanied by big profit growth. Also of concern, Zynga’s big revenue growth has been powered entirely by share-of-wallet gains, and not at all by user growth.
Big picture — I say fade the rally in ZNGA stock.
The Zynga Story Has Red Flags
At first glance, the Zynga story looks really good. Revenue growth has accelerated all year long, from 27% in the first quarter of 2019 to nearly 50% in the third quarter of 2019. The fourth-quarter guide calls for another 40%-plus revenue growth quarter. Management is also guiding for healthy double-digit revenue growth to persist over the next several years.
That’s all great news. But, there are two big concerns with this growth narrative.
The first is that all of this growth is being driven by Zynga more optimally monetizing its user base. No growth is coming from user base expansion. That is, the number of mobile daily active users on Zynga’s games has plateaued around 20 million over the past few years. At the same time, the number of mobile monthly active users has been steadily dropping. This speaks to the reality that the mobile gaming space is a niche one. For the foreseeable future, there won’t be much — if any — growth in the user base.
Thus, a bet on Zynga’s big revenue growth continuing is a bet on Zynga continuing to convince its 20 million daily active user base to keep paying more and more for Zynga’s games. That seems unnecessarily risky to me, considering the plethora of mobile entertainment competition.
The second big concern is that Zynga’s big revenue growth has not been accompanied by big profit growth. Instead, while revenues have been growing at a 30-50% rate all year long, expenses have been growing at a 50-60% rate all year long.
Thus, profit margins have compressed during this revenue ramp. This margin compression has entirely offset big revenue growth. Year-to-date, Zynga’s adjusted EBITDA is down big. It’s expected to keep dropping next quarter, too.
Zynga Stock Looks Overvalued
All things considered, Zynga stock simply looks overvalued at current levels.
The numbers aren’t too hard to follow. According to Newzoo, the mobile gaming space is growing at a 10% clip. It is likely that 10% growth in the mobile gaming space persists thanks to a broad consumer shift towards mobile entertainment. It’s also likely that Zynga grows with the market because without user base expansion, it’s tough to see Zynga reporting above-market growth rates.
On the revenue front, then, Zynga projects as a ~10% grower. Expense growth should moderate as new game expansion slows. Assuming expenses rise at a high single-digit rate over the next few years, then Zynga should also benefit from margin expansion into 2025.
Roughly 10% revenue growth on top of gradual margin expansion should drive earnings per share towards $0.50 by 2025. Based on a market-average 16-times forward earnings multiple and a 10% discount rate, that equates to a 2019 price target for Zynga stock of roughly $5.
That’s below where shares trade hands today. Thus, ZNGA stock is presently supported by hype, not fundamentals.
Bottom Line on Zynga Stock
There are things to like about Zynga is the long run. But, on the heels of a big rally and at multi-year highs, Zynga stock looks out over its skis here and now. Let the stock cool down. Let the hype fade. Then, buy the dip if/when shares drop below $5.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
