There are investments that I make which I’ll focus primarily on the probability of success. Even if the “reward” – if correct – isn’t that high, because the odds of succeeding are, the expected return is there. A high-grade Bond is a good example.

There are other investments that I make, which I’ll focus first and foremost on the upside potential, and even if the odds aren’t that great of it actually “working”, it can be a worth while investment. I blogged about this several months ago as well.

These investments are obviously more speculative in nature, so the position has to be sized accordingly.

Most importantly, just because your average Penny Stock has 100x upside potential, doesn’t mean it’ll end up in my portfolio. (Unfortunately, I never invested in $APP because of all the risks involved.)

The ideal case (which doesn’t come often), is finding an idea that has huge upside, while very little downside. I think we might have one now with $ZNGA.

Downside Risk.

$ZNGA like $FB (as I blogged about) should have never been valued at such insane valuations. So forget the fact that they were trading at $15 in March, it’s irrelevant at this point.

This is what you need to know. $ZNGA @ $2.30 has a Market Capitalization of $1.91B. As of the end of last quarter, they had $1.54B in net cash & securities. They also just purchased a San Fransisco building (for their headquarters), which according to their filings is worth $272M. That gives their actual business a value of only $98.4M.

To put in “per share” terms…. $2.30 is stock price, but they have $1.86 in net cash and another .33 in their building value.

Again, the reason I’m starting with this angle, is because when purchasing a company that has a “long shot” to succeed, you first want to know what your downside risk is. In $ZNGA’s case, you’re talking about .11 per share or less than $100M in market value.

Of course, the stock could trade under Book Value, it can even trade under cash, it can theoretically go to zero. Don’t forget however,  you’re not talking about a business like $RIMM or $NOK, that are burning cash. $ZNGA’s operations provided $146M of cash flow the first 6 months of this year. They have over 300M monthly active users, and although their business model will continue to evolve, it’s not in the same league of companies like $GRPN or $P.

The huge upside.

It all really got started in December of last year, when the Department of Justice interpreted the Wire Act to only prohibit “online sports betting” (vs prior interpretation of “all forms of online gambling”). This opened the door for online gaming legislation by the States. California, Nevada, and New jersey are leading the way.

Over the last couple of weeks, a Federal online Poker Bill titled “Poker Consumer Protection, Gambling Prohibition, Strengthening UIGEA Act of 2012″ (sponsored by Harry Reid & Jon Kyle) has been circulating. The well publicized US Fiscal issues (as well as the finances at the States level), make it more than likely that some form of legalization will occur sometime in the not too distance future.

Worldwide online gambling is estimated to be a $30Bil industry. Even in the US, where it’s currently illegal, it’s supposedly already a $5-$10Bil industry.

So while $ZNGA’s official addressable market – “social gaming” (with virtual currency) – is currently less than a $8B market, it can easily quadruple overnight. (If legalized, i would also assume that online gambling would take away share from the $100B+ brick & mortar casinos.)

There’s many reasons to why this is a “long shot”. It’s also almost impossible to quantify odds, and what the upside actually is.

First, we’re dealing with Government regulation (and if that fails, State by State regulation).

Second, and more importantly, you  have tons of players (no pun intended) in the space. Bwin.Party in Oct 2011 signed a JV with $MGM & $BYD to offer online poker if/when legalized in US. They are currently operating internationally and have a $1B+ Market Cap (London). In May, $CZR bought a majority stake in Playtika (Israeli co) to enter the space. $IGT spent $600M to purchase both Entraction in 2011 and Double Down in 2012, giving them a solid foothold. There are many other companies (public & private) that are competing in this space many of them in the “Gray market” such as PokerStars, FullTilt, Bodog etc.

According to the Bill’s draft, it looks like the online players including $ZNGA would have to partner with a brink & mortar casino. This is a huge deal. Although respected #FF List twitter friends @mojoris1977 & @Legacy_Trades opined last night that $ZNGA wouldn’t be able to do it on their own, I think they could. Why not? They have most of the structure in place with virtual money, they have the platform with the most users etc. There have been plenty of stand alone – non brick & mortar – successful players in this industry.

Either way, if the legislation passes as is, it’s a moot point, and $ZNGA would have to find a partner. $WYNN would be the most obvious option, as they terminated their relationship with PokerStars after their indictment by the NY US attorney. There have been multiple reports of talks between the two (via NY Post, via Forbes).

I think $ZNGA is in a very good position here. They have the single largest network of poker players playing their game. They have ~7M  daily active users, and ~30M monthly. Those stats are just for Zynga Poker (they also have other virtual gambling games). While some of $ZNGA’s traditional games have seen major drop-offs in their DAUs, Poker has been tremendously persistent.

$ZNGA knows this very well. In last night’s CEO update, Mark Pincus wrote (emphasis mine):

Team,

Today we announced preliminary Q3 financial results and revised our forecast for the rest of the year.  I want to add more color to the announcement and our future opportunity.

The challenges we faced in our web business in Q2 continued in Q3 and while many of our games achieved plan, we still experienced overall weakness in the invest and express category. To address this we’re further investing in other genres like casino where we already lead with Zynga Poker and blue PVP, a category we pioneered with Mafia Wars, and now have the opportunity to reinvent with the industry’s best talent here at Zynga.

Bottom line.

Can $ZNGA go lower? Yes.
Do I think it goes much lower? No.
I think the company, with their 300M+ monthly active users, making money, decent business model will hang in there.

On the upside, i think there’s a 5-10x return potential.

The biggest risks imo to this thesis are the continued exodus by executives and key personal, the continues share issuance by the company to acquire / maintain talent (therefore diluting shareholders), & the potential class action lawsuits/headline risks.

You can see my $ZNGA spreadsheet here.

- MicroFundy