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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It's happened again. Earlier this month, Zynga (NASDAQ: ZNGA) stock received an upgrade to neutral (with a 30% increase in price target) from Bank of America Merrill Lynch. Three weeks later, Zynga has just won its second endorsement -- this time from Piper Jaffray.
And here's even better news for Zynga shareholders: Whereas Merrill only estimated Zynga's value at $3.25 per share (which is less than the stock costs today), Piper Jaffray thinks Zynga stock could go as high as $4 a share -- 23% more than Merrill thinks it's worth, and 12% more than Zynga's current cost. Accordingly, Piper Jaffray is recommending that investors overweight the stock.
Here are three things you need to know about that.
Image source: Zynga.
1. How it all began
This story all started earlier this month, when Zynga reported fiscal Q1 2017 earningsthat showed revenue rising 4% year over year, but operating costs falling 5%. Zynga's rising revenue and falling costs weren't enough to turn Zynga profitable last quarter (Zynga lost a penny a share). But to Merrill Lynch, they seemed propitious enough to deserve an upgrade, and a prediction that "sustainable growth in revenues and profitability" were on the horizon.
They're also key to why Piper Jaffray is upgrading the stock today.
2. Piper's predictions
Piper Jaffray lays out its predictions this morning in a write-up covered on StreetInsider.com, and they're pretty straightforward: Unlike certain other gaming companies, which make big investments in hopes of creating "the next home-run title," Zynga is investing in its live services for gamers, and on "cost containment" for its own business.
Piper sees this as a lower-risk way for Zynga to claw its way back to profitability, than investing large sums of cash in trying to develop a breakout hit -- investments that may or may not pay off. According to Piper, Zynga's approach emulates the way Electronic Arts (NASDAQ: EA) turned itself around a few years ago. Crucially, Piper also points out that "most of the key players" in Zynga's management are veterans of Electronic Arts, and so will presumably read from the same "playbook" at Zynga that they employed at EA.
In this regard, S&P Global Market Intelligence research reveals that Zynga's CEO (Frank Gibeau), CFO (James Griffin), and COO (Matthew Bromberg) are all Electronic Arts veterans, each having jumped to Zynga in 2016.
3. Piper's predictions -- by the numbers
So how does Piper Jaffray expect this team of gaming all-stars to save Zynga, specifically? By cutting costs significantly and growing revenue gradually, Piper predicts Zynga will end this year with losses of $0.04 per share, but then emerge into profitability next year, earning $0.02 per share.
(Lest you think this is starry-eyed optimism on Piper's part, it's worth pointing out: Piper's prediction of a $0.02 profit at Zynga next year is actually only half the $0.04-per-share profit that most analysts expect to see. In other words, Piper Jaffray is more conservative than most analysts in gauging Zynga's potential -- yet it still sees the stock as a buy.)
Final thing: Reality check
So how does Zynga prove Piper Jaffray right? How does it get from Point A (unprofitability) to Point B ($0.02 a share)? Let's take a look at the numbers.
Last year, before most of Zynga's new management team was in place, Zynga spent $238 million on cost of goods sold (COGS), $613 million on operating expenses, and deducted all this from only $741 million in revenue. Put it all together, and Zynga started out $110 million in the hole even before Uncle Sam had a chance to look around and assess taxes.
For Zynga to earn $0.02 per share, it needs to earn roughly $17 million to account for the 860 million shares it has outstanding. Thus, focusing solely on operating profit, to earn $0.02 per share, Zynga needs to grow profits by $110 million plus $17 million, which equals a $127 million mountain to climb.
In Q1, Zynga took about $8 million worth of steps forward by growing revenue, $8 million worth of steps back in higher COGS, then advanced another $15 million through cuts in operating costs -- altogether, making $15 million worth of progresstoward its goal. Assuming the company can repeat this feat each quarter going forward, it should take about eight-and-a-half quarters' worth of steady progress for Zynga to reach $0.02 in annual profit. Accelerate the rate of financial improvement only a bit, and in theory at least, Piper's prediction of $0.02 in profits by the end of 2018 doesn't look entirely unrealistic.
Of course, this still leaves us wondering whether $0.02 per share in profit is enough to justify Piper's price target of $4 a share (making for a P/E ratio of 200). But that's another question entirely.
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