NEW YORK (TheStreet) -- An old tech dog can learn new tricks. That's what Zynga's (ZNGA) shareholders are wagering three years after the San Francisco game maker IPO'd. The shares have painfully shed more than 80% of the highs made in early 2012, albeit there's plenty of reason to remain optimistic.
Earlier this month, Zynga's chief handler, Don Mattrick reported a modest bookings beat, but enough to lift the already astonishingly low expectations, and send shares markedly higher. The earnings surprise is good news, although not nearly as significant as the company's mobile growth. We will explore the mobile growth in depth, but first, let's look into the earnings report and see what's under the hood.
Deciding if the market is more irrational for not seeing this one coming or for allowing the shares to fall as far as they have beforehand is a challenge. One thing's for sure, finding growth potential on the top and bottom lines isn't challenging. However, the earnings report does contain more than one concerning aspect.
The number of shares continues to grow. The weighted average number of shares in the first nine months of 2013 was 791 million. In the last three months, that number climbed to more than 880 million. In and of itself, maybe not that significant, but the company recently completed its last share buyback program and hasn't announced another.
Shareholders become increasingly diluted if the company continues to issue employee stock options, and of course the previously issued options, absent company buybacks aren't helpful for the average investor. Then there's that pesky GAPP accounting to deal with.
So many in the media are willing to write a headline stating the company "only" lost a non-GAPP penny a share instead of the actual 6 cents in the last reported quarter. Sure, maybe if investors don't count recurring expenses, but when was the last quarter non-recurring charges didn't occur? Remember, non-GAPP doesn't mean non-real money.
Speaking of interesting accounting, Item 1, Page 1 in the report is the consolidated balance sheet. Take a look at goodwill and the charitable allocation the bean counters bestowed upon its value. This line item is especially curious because at the beginning of 2014 when the stock was trading near $3.80 a share, the goodwill valuation was $228 million. Now, nine months later when the collective minds of the market have discounted the shares to $2.65, the company's goodwill is suddenly worth $675 million. In other words, Zynga's assets increased $447 because accountant gymnastics allowed the CPAs to populate that number in the spreadsheet cell.
Increasing goodwill also happens to flow very nicely towards the bottom into the total assets to provide a slight increase from the beginning of the year. The quarter's total assets were $2.39 million versus $2.28 million at the end of 2013. Even after adjusting for shares outstanding, it's a challenge to get my head wrapped around that one. Kudos to the accounting team for its amazing appraisement mastery.
Obviously, it wasn't all bad, and in fact, after pushing past the smoke and mirrors side-show, it becomes evident that this tech company is joyously undervalued. Joyously because when you can buy something that you believe is worth $6 or more for less than $3, it's a good day. Granted, it can take a while for the market to figure it out, but if it didn't, the average investors wouldn't have a chance, would they?
Earning's releases are a prime example. Look at how lightning fast share prices move immediately after an unexpected earning's announcement. Never look at the required holding period as a burden, because it's often a blessing. Without it, there is no market, not at least for the average investor. Zynga's development and must-watch metrics shined above the accounting wizardry, and it remains my focus.
If you listened to the earnings call and or examined the 10-Q (third-quarter earnings report), more than a few somewhat subtle, but meaningful directional keys appeared. First and foremost, mobile now accounts for over half of Zynga's revenue. Mobile growth has implications far beyond the current quarter's results.
Zynga's mobile expansion by default means Facebook's (FB) chokehold on Zynga's collar is waning. Keep in mind that it was Facebook's essentially unilateral contract of adhesion that left Zynga with an abysmally small chance ever to profit, much less prosper. If Zynga was ever going to transcend, it had to rid itself of that uncouth dependency, and thankfully for shareholders, every indication demonstrates it is.
Zynga also stated that its primary directive is mobile, and it's filling the 2015 pipeline with mobile games. It's Mattrick's expertise and drive into mobile that keeps me up at night working on valuation models depending on various levels of upcoming content success. If we discovered anything from King Digital Entertainment (KING) , we learned that all it takes is one big hit to inflate the share price and investor confidence.
It's all just the first act though. Mattrick turned a sleepy software company into a gaming leader at Microsoft (MSFT) , a company I expected would reach $50. He is now making all the right moves to do the same at Zynga through purchases of NaturalMotion, content licensing agreements with Tiger Woods and other sports-related content.
Imagine the upcoming and improving content from Zynga quickly increasing the potential take-over appeal the company is likely to create when its book of games expands next year. While surprising for many, China is expected to become the largest mobile marketplace, if it hasn't already, and the average mobile user in China spends more per phone than the average user in America. Zynga is in the right place, at the right time, with the right leader, and with the right product.
Simultaneously, as reported earlier, Baidu (BIDU) , Alibaba (BABA) Tencent, Sohu.com (SOHU) , SINA (SINA) , and others are feverishly buying mobile content creators due to a lack of premium content to sell in the Middle Kingdom. When placed into that context, the seemingly rich NaturalMotion takeover valuation paid by Zynga makes a whole lot more sense.
Yes, it was a positive earning's release, but if team Mattrick can continue to execute, the best is yet to come in 2015.
At the time of publication, Weinstein is long Zynga.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.
TheStreet Ratings team rates ZYNGA INC as a Sell with a ratings score of D. TheStreet Ratings Team has this to say about their recommendation:"We rate ZYNGA INC (ZNGA) a SELL. This is driven by several weaknesses, which we believe should have a greater impact than any strengths, and could make it more difficult for investors to achieve positive results compared to most of the stocks we cover. The company's weaknesses can be seen in multiple areas, such as its deteriorating net income and disappointing return on equity."
You can view the full analysis from the report here: ZNGA Ratings Report