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Zynga Inc. (ZNGA - Snapshot Report) reported better-than-expected third quarter 2012 results. Accounting for stock based compensation expense of $37.8 million, net one time charges and gains of $171.0 million and tax effect of $34.4 million on these items, Zynga lost 3 cents per share, much narrower than the Zacks Consensus Estimate of a loss of 8 cents.

On a non-GAAP basis, the company reported a break-even figure, which however was down from 4 cents reported in the previous-year quarter.

Quarter Details

Revenue climbed 3.2% year over year to $316.6 million, well ahead of the Zacks Consensus Estimate of $256.0 million. Advertising (9.8% of the total revenue) soared 63.7% year over year to $31.0 million. Online game revenue (90.2% of the total revenue) remained almost flat on a year-over-year basis at $285.6 million.

Zynga launched 4 games (2 web based and 2 mobile) during the third quarter.  Bookings decreased 11.1% year over year to $255.6 million in the reported quarter. Daily Active Users (DAU) jumped 10% year over year to 60 million, while Monthly Active Users (MAU) jumped 37% year over year to 311 million.

However, the revenue growth was fully offset by a steep increase in total costs & expenses, which spiked 50.2% year over year to $413.2 million. Zynga continues to invest heavily in product development, which is reflected in a 35.5% increase in research & development expense in the quarter.

On the other hand, sales & marketing expense declined 16.2% year over year to $36.6 million in the quarter. General & administrative expense also decreased 2.7% year over year to $35.4 million. 

Adjusted EBITDA was $16.2 million in the quarter, a sharp decline from $58.1 million reported in the previous-year quarter.

Zynga reported non-GAAP net loss of $0.4 million in the quarter compared with net income of $31.7 million a year ago.

At the end of third quarter, Zynga had cash and cash equivalents (including marketable securities) of $1.32 billion compared with $1.22 billion in the prior quarter. Zynga generated cash flow from operating activities of $30.1 million versus $67 million in the prior quarter. Free cash flow was $16.7 million. The company announced a $200 million share buyback plan.

Outlook

Zynga lowered its expectations for fiscal 2012. The company now expects earnings in the range of 2 cents to 3 cents (prior guidance was 4 cents to 9 cents) per share. Stock-based compensation expense is projected in the range of $310 million to $325 million for the year.

Bookings are projected in the range of $1.09 billion to $1.1 billion (prior guidance was $1.15 billion to $1.225 billion). The company expects to launch two new web based games and four new mobile game in every quarter throughout next year.

Adjusted EBITDA is estimated in the range of $152 million to $162 million (earlier guidance was $180 million to $250 million) for fiscal 2012. Capital expenditures are anticipated in the range of $338 million to $343 million for fiscal 2012.

Moreover, management also outlined its cost cutting initiatives, scheduled for the fourth quarter. Zynga plans to reduce workforce by 150 employees. Additional cost reduction measures include rationalization of its product pipeline and containing costs related to marketing and technology expenditures.

Management also expects consolidation of certain facilities. Through these initiatives, management expects pre-tax savings between $15 million and $20 million.

Zynga also announced a share repurchase program under which the company is authorized to spend $200.0 million.

Our Take

We believe that Zynga is well positioned to grow in the near term based on its innovative product pipeline and its dominant position in the social and mobile gaming sector. Moreover, shareholder friendly initiatives such as the buyback and cost reduction program will drive the stock in the near term.

However, higher spending on research & development, technology and game development are expected to hurt profitability going forward. Further, Zynga’s low-paid user base and over dependence on Facebook (FB - Analyst Report) may hurt its growth going forward.

We also note that barriers to entry are low in the social gaming market and this will attract new entrants, thereby further increasing competition for Zynga over the long term. Moreover, competition from Electronic Arts Inc. (EA - Analyst Report) andInternational Game Technology (IGT - Analyst Report) in the social gaming segment are the other headwinds going forward.

Thus, we remain Neutral over the long term (6-12 months). Currently, Zynga has a Zacks #2 Rank, which implies a Buy rating over the short term (1-3 months).

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