Zynga Stock Upgraded on Earnings Beat: What You Need to Know

By Rich Smith Markets Fool.com

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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Social gaming stock Zynga (NASDAQ: ZNGA) reported its fiscal Q1 2017 earnings yesterday, and missed its numbers pretty badly. As StreetInsider.com reports, Zynga was expected to earn $0.01 per share in Q1, but instead reported a $0.01-per-share loss.

Or did Zynga miss? Reading the same report that other analysts read (as a miss), Cowen & Co.released a note this morning crediting Zynga for a "substantial beat" in Q1. As Cowen sees it, Zynga earned $0.02 per share (pro forma), and this number was above the analysts' predicted $0.01. And so, presto-chango, Cowen transformed a miss into a beat.

Now here are a few other things you should know about that.

Image source: Zynga.

1. Begin at the beginning

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Before we begin parsing the analysts' analyses of Zynga's earnings, let's take a look at the numbers themselves, and see what they say. Zynga reported its fiscal Q1 2017 earnings yesterday after close of trading. According to the report:

  • Zynga booked $194.3 million in revenue in Q1. Online game sales increased 12%; advertising "and other" revenue declined 18%. All told, the company's revenue grew 4% year over year.
  • Zynga cut its costs substantially in comparison to last year's Q1. Nevertheless, costs outstripped revenue, leaving the company with a $9 million operating loss for the quarter (albeit better than last year's $26.9 million loss).
  • On the bottom line, Zynga's GAAP loss was $9.5 million, or $0.01 per share (versus last year's $0.03 per share loss).

So there. That should clear up the analysts' confusion for you. Zynga lost money for the quarter, plain and simple. It did, however, lose less money than last year -- so that's a plus.

2. Wall Street math

How does Cowen look at these numbers and conclude that Zynga made money last quarter, and not only that, but made more money than other analysts had predicted? That's not entirely clear.

Cowen may be counting funny money -- "pro forma" earnings, which the analysts have lately taken to calling "adjusted" earnings. Or it may be relying on "adjusted EBITDA," which is even one step further removed from actual GAAP profits. Cowen says that Zynga booked $29.6 million in adjusted earnings before interest, taxes, depreciation, and amortization, and notes that this was above the $21.2 million that Cowen had expected the company to book in Q1. (Zynga's actual report, mind you, says that its adjusted EBITDA was $16.7 million, so Cowen may be confused on this point.)

On the bottom line, though, the fact still remains: Zynga lost money last quarter. It didn't earn money.

3. Other analysts chime in

That said, Zynga did lose less money than it lost a year ago, and that has some analysts cheering. Merrill Lynch, for example, argues that while Zynga may not yet be profitable, "Zynga's new focus on in-game content has helped accelerate usage of its core franchises and we now think Zynga can drive sustainable growth in revenues and profitability" at some point. Accordingly, Merrill went so far as to upgrade the stock from underperform to neutral, and hiked its price target on the stock 30% to $3.25 per share.

There's some reason to believe Merrill is right about that, too. For example, "bookings" of revenue amounted to $207.4 million in Q1 (with some of that revenue deferred to later quarters), which was 14% higher than the company's Q1 2016 number. This implies that revenue really is accelerating -- and profits may follow.

Simultaneously, Benchmark Capitalreiterated its buy rating on Zynga stock, with a $3.65 price target, arguing that Zynga's cost-cutting and "focused games slate" will continue to drive growth at the company.

The upshot for investors

Thus -- Cowen's endorsement aside -- Wall Street seems to be making a good case for Zynga having put its house in order. Revenue is growing and costs are falling. True, the company remains unprofitable. On the other hand, though, S&P Global Market Intelligence data confirm that Zynga is still throwing off a considerable amount of cash -- $48.7 million in positive free cash flow over the past 12 months.

At its current enterprise value of $1.75 billion, this still works out to a very pricey 35.8 enterprise value-to-free-cash-flow ratio on the stock, and I'm not entirely convinced that the stock's projected 21% long-term profits growth rate is fast enough to support that valuation.

Wall Street is right about Zynga's business having improved significantly. That said, I also think Merrill Lynch is right to remain cautious, and only "neutral" on the stock at its current valuation. Zynga's doing better -- but it's not a buy yet.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.