Zynga: From Social Gaming Hero to Complete Zero?

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Social game maker Zynga (NASDAQ: ZNGA) recently surprised Wall Street by posting better than expected growth on both its top and bottom lines. But does it make up for the 70% plunge shareholders have endured since the company went public in December 2011? Although some investors believe that Zynga's casual games represent the future of gaming, others believe that they are a fad which will never produce enough revenue to outweigh expenses. Let’s examine Zynga’s business model to see which argument is true.

A Turnaround Quarter?

For its fourth quarter, Zynga posted a loss of 6 cents per share, a considerable improvement from the loss of $1.22 per share it posted in the prior year quarter. Although earnings edged towards profitability, revenue declined 15% to $261 million. 

The decline in revenue and rise in earnings were actually positive signs, since the main problem Internet growth stocks have faced is soaring revenue coupled with surging expenses, which often result in great top line growth but a broken bottom line. Zynga’s convergence of revenue and earnings shows investors that it’s finally getting its costs under control.

Last October, CEO Mark Pincus shut down Zynga’s Boston office and laid off 150 staff in its Austin office in an effort to lower expenses.

The Foolish Fundamentals

So far, those initiatives have appeared to stabilize Zynga’s fundamentals.

<img src="http://media.ycharts.com/charts/cdb267a57099db806ecab76ec3ff32ab.png" />

ZNGA Revenue TTM data by YCharts

Although the company’s earnings and margins growth are still overwhelmingly negative, its cash reserves and revenue growth have remained comparatively stable. 

This contributes to Zynga’s fairly strong financial position, as seen from these metrics.

<table> <tbody> <tr> <td>Cash Reserves</td> <td>Net Debt</td> <td>Debt to Equity</td> <td>Price to Book</td> </tr> <tr> <td>$1.3 billion</td> <td>$100 million</td> <td>5.39</td> <td>1.03</td> </tr> </tbody> </table>

Source: Yahoo Finance

Zynga has surprisingly low debt and trades near book value, making it fundamentally undervalued. If Zynga can push back into the black, then perhaps it can even be considered an undervalued growth stock. Zynga’s cash position is so strong that it was able to initiate a $200 million stock buyback last October - an unusual move for a growing social media company.

Despite these positive signs, there are some major hurdles Zynga has to overcome.

Facebook 'Unfriends' Zynga

Zynga once held a 60% market share in Facebook (NASDAQ: FB) games, and generated approximately 80% of its revenue from Facebook. That looks to change soon, since starting March 2013, a Facebook account can no longer be used as a dual login for Zynga platform games. Zynga will no longer have exclusive rights to the Facebook Payments platform, but it will be allowed to offer other methods of payment - such as credit cards or PayPal.

In exchange, Zynga will also be allowed to offer games on its own site, and no longer be required to display advertisements from Facebook. Facebook takes a 30% cut of Zynga’s revenue, so the decision to cut Zynga loose was unusual, but analysts see it as part of a strategy to limit the company’s exposure to social gaming, a highly volatile industry. Facebook has been criticized for its dependence on Zynga, which generates 14% of the company’s annual revenues.

While some believe Zynga’s newfound independence will usher in an era of growth, I firmly believe the opposite. Without Facebook, Zynga has lost its greatest ally and benefactor.

How does Zynga generate revenue?

Most people are baffled by how Zynga makes money. Just how does planting crops with friends translate into hundreds of millions of dollars in revenue? Two ways: microtransactions and display advertising.

Microtransactions are tiny real money purchases inside the game - for example, a regular non-paying player in Farmville might have to wait four hours for his crops to grow, while a paying player could compress the time significantly with a purchased item. Certain high-spending players, called “whales” in the social gaming industry, have paid over $20,000 annually for these virtual items.

A smaller percentage of Zynga’s revenue comes from advertising. These are usually banner ads on the top and bottom of the screen, but can also be videos which intermittently display between levels. Advertisers sometimes also offer “incentive based” virtual credits to players who voluntarily watch their advertisements. Companies can also place their products into the game themselves as virtual product placement.

Zynga’s core competency is simulation games, such as Farmville or The Ville, since these generate the most return visits. Zynga currently controls 58% of the simulation games market. However, Zynga’s grip on this market has been slipping, due to the waning popularity of the genre. Since the start of 2011, the popularity of all simulation games on Facebook has plunged from 64% to 29%. 

Imitation leads to stagnation

The resulting desperation for a new hit title has led to a lack of innovation at Zynga. Most of Zynga’s most popular games have been cloned from other companies. For example, Zynga’s City Cafe and The Ville were identified as respective imitations of Restaurant City and The Sims Social, both from Electronic Arts

EA has already sued Zynga over the disputed games, but other smaller publishers lacking the legal firepower have not had that luxury. This culture of imitation has led to stagnation in Zynga’s titles.

In my opinion, the $200 million Zynga spent on its stock buyback to appease shareholders would have been better spent on R&D for new intellectual properties.

Mobile Growth

In 2013, Zynga sees a bright future in mobile gaming. The company stated that 72 million of its 298 million active users now play its games on smartphones or tablets. That’s nearly a quarter of its total users, and represents a 75% increase in mobile gamers from the prior year quarter.

The Bottom Line

Although Zynga has shown positive signs of recovery and may even return to profitability in 2013, the company must address several major concerns:

  • Electronic Arts’ rising market share in Facebook games
  • Low barriers for competitors in an increasingly fragmented market
  • Lack of original games
  • Declining popularity of simulation games
  • Sustainability of the microtransactions culture

However, Zynga’s low debt, rising popularity in mobile gaming, and disciplined cost-cutting initiatives show that this fallen social media hero is not a complete zero - yet. But it must also show investors that it can further converge revenue and earnings growth, as well as operate without Facebook's support, to prove itself as a worthy investment.

Leo Sun owns shares of Facebook. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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