Three Reasons Zynga Inc Deserves A Sell Rating

Zynga Inc stock has declined more than 57% from the March 12 high of $5.79. It makes the company’s valuation less risky. According to Jefferson Research, the social gaming company’s earning quality is strong. But the research firm remains bearish on the stock due to three reasons: a weak balance sheet, pathetic operating efficiency and poor cash flow quality.

Zynga’s cash flow quality gets ‘Weakest’ rating

Cash flow quality is more reliable than reported earnings and is a very good measure of a company’s performance. Jefferson Research rated Zynga’s cash flow quality as ‘weakest,’ even though the operating cash flow quality showed YoY improvement. The company reported annual operating cash flow of $28 million, while Jefferson’s adjusted figure was $119 million less than the reported number. The research firm eliminates items that are not the result of actual operations or part of recurring cash flow to get a “truer measure of cash flow.”

Zynga Cash flow

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Zynga Flow

Zynga’s operating efficiency is no better. The company’s EBIT margin, net margin, SGA costs and gross margins have improved over the last quarter. But its return on invested capital and return on incremental investment capital have worsened in the same period, says Jefferson Research. Zynga’s gross margin has declined from about 87% in Q3, 2013 to slightly above 80% in the latest quarter. The adjusted EBIT margin has gone downward from 20% in Q2, 2012 to a negative 30% in the third quarter this year.

Zynga gross margin

Zynga Net margin

Zynga’s cash position improves, but…

Finally, Zynga’s balance sheet is still weak. Balance sheet reflects the company’s ability to pay its bills and fund its future growth. Zynga’s cash position, current ratio and quick ratio improved from the last quarter on the strength of better receivables and inventory positions. The San Francisco-based company’s cash position improved from $777 million to $873 million, which should help the company better meet its financial obligations. Its quick ratio also improved from 2.5x to 2.6x. These positive signs were not sufficient to dramatically improve the balance sheet rating.

Zynga Balance sheet

Zynga current ratio