Mobile video gaming has turned into a big growth market, and as it has, shares of dominant mobile video game publisher Zynga (NASDAQ:ZNGA) have soared. In late 2018, this was a $3.50 stock. In early 2020, Zynga stock nearly touched $7.
That’s roughly 100% upside in just over a year. Can the red-hot rally continue?
I have my doubts, mostly because there are some red flags with the Zynga growth narrative, and because the valuation underlying Zynga stock seems full when you consider those red flags.
At the same time, though, there’s a lot of excitement surrounding the mobile video game market at the current moment. I don’t see that excitement fading in 2020, as strong product launches from Zynga should support continued bullishness.
Net net, I don’t think ZNGA stock will rise much from here over the next few months. Nor do I think it will fall much. Instead, I think shares will simply fall flat.
Zynga Has Red Flags
The Zynga growth narrative has two major red flags.
First, Zynga’s big revenue growth year-to-date (revenues are up 40% year-to-date) is being driven entirely by share-of-wallet gains, and not at all by user growth. Daily active users of Zynga’s games has plateaued around the 20 million mark for several quarters. Monthly active users has actually steadily dropped all year long from 78 million a year ago, to 67 million today. Meanwhile, average revenue per user has soared all year long, with the growth rate through the first three quarters averaging to over 40%.
I don’t think this is sustainable. Share-of-wallet gains are easy to come by this year because average spend per user is so low. As that number gets bigger, big growth will be harder to come by. At the same, there’s huge and increasing competition for mobile content dollars. Think Netflix (NASDAQ:NFLX), Spotify (NYSE:SPOT), YouTube, etc. Considering that backdrop and that the laps are getting tougher, Zynga’s average revenue per user growth rate will likely decelerate meaningfully in coming years.
Users won’t go higher, either. At its core, mobile video gaming is niche. Most consumers get their mobile entertainment fix through social channels like Facebook (NASDAQ:FB), Snap (NYSE:SNAP), and Tik Tok. Without user growth, the whole Zynga growth narrative is set for a big slowdown over the coming years.
The second red flag is that revenue growth is being driven by big expense growth. Zynga’s revenues are up 40% year-to-date, while expenses are up 60%. Profit margins are in retreat, and profits actually aren’t ramping higher. So long as this remains the case — and it may remain the case for a while considering Zynga’s huge competition in the mobile channel — Zynga stock will have a tough time justifying its valuation.
Zynga Stock Seems Fully Valued
Considering those two red flags, Zynga stock appears fully valued at current levels.
According to Newzoo, the mobile gaming space is growing at a 10% clip. The market will likely sustain 10% growth thanks to gradual growth in average spend per user. In that market, Zynga is supported by an impressive content portfolio, the likes of which will allow it to maintain market share, even amid increasing competition from Apple (NASDAQ:AAPL) and others.
Broadly, Zynga most reasonably projects as a 10% revenue grower over the next few years. In a best case scenario, Zynga will start moderating its spend as it gets bigger and expense growth rates will slow to below 10%. Profit margins will gradually move higher. So will profits, at a 10%-plus pace.
Optimistically assuming so, my modeling pegs Zynga’s 2025 earnings per share at 50 cents. Big time console video game publishers like Activision (NASDAQ:ATVI) and Electronic Arts (NASDAQ:EA) have historically averaged 20-times forward earnings multiples. Based on that multiple and a 10% annual discount rate, 50 cents in 2025 earnings per share supports a 2019 price target for ZNGA stock of just over $6.
That’s pretty much exactly where shares trade hands today, and we are still a week away from the end of fiscal 2019. Thus, for the moment, Zynga stock is trading near a best-case estimate for its fair value.
Bottom Line on ZNGA Stock
Zynga is a fine company. It just seems like investors got a bit too excited about growth prospects in the mobile gaming space. Yes, the mobile gaming market will continue to grow over the next few years. But, not by that much, and it will forever remain niche.
Considering this reality, Zynga stock isn’t all that attractively valued at current levels. The most likely path forward for shares over the next few months is sideways.
As of this writing, Luke Lango was long NFLX, FB, SNAP, and ATVI.
