Why Zynga Could Soon Be Acquired

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

Zynga (NASDAQ: ZNGA) is in serious trouble. Shares of the troubled social game maker seem to plunge to lower all-time lows every day. Earlier this month, I discussed several reasons why investors should avoid Zynga at all costs - its broken business model, shrinking workforce, lack of a defensive moat, and a last ditch investment in online gambling all indicate that it might be “game over” for the maker of Farmville, Words with Friends and Draw Something.

But enough doom and gloom already. If there’s any value left in Zynga shares, it’s in the hope that a buyout offer from a larger tech company could save its shares from being delisted. In this article, I’ll discuss two potential suitors for Zynga, and how they can benefit from acquiring the company, which currently has a market cap of $2.0 billion. By itself, Zynga might be doomed, but as part of a larger company, it could actually bounce back.

Some frustrating fundamentals

The big problem is that Zynga is currently unprofitable. Last quarter, the company reported a year-on-year revenue decrease of 17.9% and a profit margin of -9.8%. It also has a negative 5-year PEG ratio of -2.6, which indicates that Wall Street doesn’t expect this company to grow its bottom line anytime soon. Despite its low price, Zynga still trades with a price-to-book ratio of 1.15 and a price-to-sales ratio of 1.76, which both indicate that the stock could still be overvalued at $2 per share. To make matters worse, daily and monthly active users respectively declined 20% and 13% from the prior year quarter.

On the bright side, the company has no debt and $1.27 billion in cash and equivalents. This means that any prospective buyer could buy the entire company at a small premium over $2 billion, without assuming any additional debt.

Microsoft could use Zynga to boost its mobile presence

For Microsoft (NASDAQ: MSFT), which has $73.8 billion in cash, Zynga could be the shot in the arm that the company needs to boost its Windows Phone 8 sales. Although Windows Phone recently claimed third place in global mobile operating systems, surpassing BlackBerry, it still trails Google Android and Apple iOS significantly with a tiny 3.2% market share.

Although Windows Phone 8 devices, especially those from Nokia, have been well received for their creatively designed “Live Tiles” and fluid operating system, many users have complained about the lack of Windows Phone 8 versions of popular apps and games that are readily available to Android and iOS users. To remedy this, Microsoft is now offering all developers $100 for any app published in the Windows store by the end of the month.

With 145,000 apps in its app store, Windows Phone 8 is no slouch, but that number pales in comparison to Google’s Play Store and Apple’s App Store, which each feature over 700,000 apps. Many crucial apps, such as Instagram and Vine, aren’t available yet on Windows Phone 8, much to the chagrin of many users.

However, investing in Zynga could change all that. Although Zynga’s numbers are dwindling, bringing mobile games such as Words with Friends, Farmville, Draw Something and Zynga Poker could convince many Windows Phone users that they aren’t that far behind their Android and iOS wielding peers. Offering Zynga games on Windows Phones could also force the company’s primary competitors - Candy Crush creator King and Electronic Arts - to port their games over to Windows Phone as well. Suddenly, Windows Phone 8 won’t seem like a barren wasteland for gamers anymore.

Being purchased by Microsoft would also solve Zynga’s weak cash flow, which stood at $21.5 million at the end of last quarter. Microsoft could merge Zynga into its Microsoft Studios division, giving it the license to create casual versions of its more popular franchises, such as Halo and Fable. Zynga could then have some firepower to fight back against EA, which has steadily eroded Zynga’s market share with flashier titles based on more popular franchises.

Activision could diversify into social games

As a former Activision Blizzard (NASDAQ: ATVI) shareholder, the thing I’ve always loathed about the company is its lack of diversification. The company’s entire business model is based on Call of Duty and World of Warcraft, and a slip in customers in either franchise generally result in shares plunging. However, the company has recently concentrated on diversifying into other titles - such as Blizzard’s Starcraft 2 and Diablo 3 - and hybrid toys with Skylanders. Therefore, diversifying into social games would be a logical next step, since its primary competitor, Electronic Arts, is already there.

Activision currently has $4.6 billion in cash and no debt, more than enough to comfortably acquire Zynga. Zynga generated $1.2 billion in annual revenue last year, compared to Activision’s $5.0 billion. Based on its 2012 revenue, purchasing Zynga could make social games 19% of Activision’s annual top line. Although that could be too large of a position to bet on social and mobile games, it could turn the attention away from its dwindling World of Warcraft numbers, which spooked investors last quarter.

Just like Microsoft, Activision could juice up Zynga’s line of mobile games by allowing Zynga to create social and mobile versions of its popular franchises, such as Diablo, Starcraft and Call of Duty. A mobile version of Starcraft, perhaps created as a turn-based strategy game rather than a real-time one, could be a huge hit. A mobile version of Call of Duty or Modern Warfare could usher in a new era of smartphone-based multiplayer first-player shooters. No longer would Zynga be confined to creating lower-budget farming and Scrabble clone games - it would be able to create some triple-A mobile games to fire back at EA.

The Foolish Bottom Line

Microsoft and Activision are only two companies which could potentially take Zynga off the market. Any number of major Asian companies, such as League of Legends creator Tencent, Chinese gaming giant Netease and Chinese search behemoth Baidu could all be motivated to acquire this fallen icon of social gaming, for many of the same reasons.

Although I don’t recommend investors to simply buy Zynga in hopes of a buyout, I believe that it is distinct possibility, considering Zynga’s attractive stable of games, its large customer base of 253 million active monthly users, and its cheap stock price. Usually these market consolidating buyouts occur in the middle of a market swoon such as the current Bernanke-induced meltdown, so investors should keep their eyes peeled regarding any takeover buzz about Zynga.

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Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard and Microsoft. 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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