Size Matters In Video Games

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

Note: The original version of this post reported that Zynga was closing its Baltimore office. Zynga's VP of communications says the company "did not announce anything related to the larger Baltimore studio nor did we close that office as your blog suggests." That portion of the post has been removed.

Social gaming company Zynga (NASDAQ: ZNGA) recently announced that it is losing a key top-level employee, its chief game designer. This is a bad sign for a company that once looked like it would usher in a new world of gaming. While it did, in fact, help pave the way for so-called casual games, its business model isn't holding up to public life and the firm is making a big shift to mobile games. However, the video game industry is far bigger than social games, and there are other options to consider—some of which have happily taken up the casual game torch.

We build this city on Facebook
Zynga hit it big making games that people play on Facebook (NASDAQ: FB). It proved to be a mutually beneficial relationship, as Facebook loved that Zynga's games kept people on its site (making the site more “sticky”). Zynga, meanwhile, loved that Facebook had a massive ecosystem of ready made customers.

Since the games Zynga “sells” are basically free, it makes money with small, in game purchases. Playing Farmville (a farming game)? You could do it free or buy a fancy tractor for a buck or two. While most people don't care enough to buy the expensive tractor, many do. Multiply this by enough games and gamers and you have a real business, with Facebook taking a cut, of course.

When the company went public, it made sure to point out that its reliance on Facebook was a big risk factor since virtually all of its revenue came from that single customer source. It made a big thing of its efforts to build a web site where people could play its games outside of Facebook, but that effort, while noble, isn't enough to change the basic reliance on a single social network. Now, the company is working to cut costs and refocusing around mobile gaming.

Market gets wise
It took a little bit for the social media pixie dust to wear off, but it did. The company's stock has gone from around $15 to around $2. Facebook's very public initial public offering fiasco didn't help any, nor has that company's difficulty in turning user information into revenues. The big risk for Zynga, and Facebook, is if customers are turned off by the social network's efforts to make money. Less customers means less money for both companies.

<img src="http://media.ycharts.com/charts/59b0473d63eaa52c8069857aa44a6ab2.png" />

ZNGA data by YCharts

Now, Zynga is trimming its staff, closing offices (an office in Japan was shuttered), and a top game designer is leaving. These are not the actions of a company that is doing well. These are actions of a company trying to regroup. In fact, it looks like Zynga might be acquisition fodder for a larger company looking to get a better foothold in the social media space.

Better options
There is no doubt that video games are a big business. However, Zynga looks like it is on the ropes. That isn't to say that there is no value in its games, just that it might not be a viable stand alone business. Investors interested in the video game space should look at Activision Blizzard (NASDAQ: ATVI) and Electronic Arts (NASDAQ: EA) as alternatives.

Activision Blizzard sells some of the most deeply immersive multi-player games available. World of Warcraft, Call of Duty, and Diablo are just some of the titles that have elicited dedicated, no ravenous, fans. These games are the exact opposite of the casual games that Zynga sells. However, these are the types of games that customers are willing to pay big bucks to play, from the computers used to the actual cost of the games, the sequels, and the expansion packs.

Two things about Activision Blizzard should be interesting to investors. First, the company is starting to enter the casual gaming space. It is using a “hired gun” approach, so its costs are likely to be reasonably low, as are its risk of failure. Moreover, it has the chance to learn without having to dive in all at once. Thus, Zynga could make acquisition sense at some point down the road when management is more comfortable in with the casual space.

Second, and far more important, the company is experimenting with an auction model within its Diablo game. Essentially, it offers a sort of eBay (EBAY) for in game products, letting users auction off the items they don't want or need to the highest bidder for real money. Activision Blizzard will get a cut of each transaction. Expand that across its entire lineup of multi-player games and it could be an industry changing advance.

Electronic Arts has been more aggressive in the casual game space, purchasing game makers PopCap and Playfish. This has quickly given the company a notable position in the social media gaming space. That said, Electronic Arts is far more than just that, like Activision it has a collection of notable franchises, including the John Madden football series, FIFA soccer series, and The Sims titles.

Many of these games allow users to interact online with friends and strangers. Two games, the Battlefield and Star Wars: The Old Republic titles, are similar in nature to the multi-player games sold by Activision. The Star Wars game is relatively new and making a notable name for itself.

The big takeaway from Electronic Arts, however, is its move to incorporate casual games into its business. This has included the two purchases noted above, but also taking current titles and extending them to the social media space in a new way. This could be a powerful tool to keep current players engaged when they are away from their gaming computers and entice new customers to become more serious gamers.

Games are fun
People love to waste time playing video games, which are touching more and more people's lives now that casual games have taken off. Zynga may have been instrumental in getting casual games a serious audience, but it isn't the best game maker around because of its tight focus. Activision Blizzard and Electronic Arts are much better game makers and, for those interested, Activision pays a small dividend.

Yours,
Reuben Gregg Brewer 


Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard, eBay, and Facebook. The Motley Fool owns shares of Activision Blizzard, eBay, and 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.

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