This Company Will Be Gone in 10 Years

By William Bias - August 29, 2012 | Tickers: KO, EBAY, FB, ZNGA | 0 Comments

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To be a successful investor a person has to invest for the long-term. In order for a company to be a viable long-term investment it has to have a sustainable competitive advantage. In other words a company has to sell a product or service that a person or a business can’t live or operate without its existence. Coca-Cola (NYSE: KO) comes to mind because they have the distribution capability to cheaply provide a product to grocery stores who rely on the steady business provided by the popularity of its brand. The brand recognition is backed by over a hundred years of tradition. I also think of eBay’s (NASDAQ: EBAY) PayPal. I can’t imagine doing business with an unrecognized entity on the internet without using that payment interface. Unfortunately, I don’t think of sustainability when I think of Zynga (NASDAQ: ZNGA). In fact, I have six reasons why I think this company will be gone in 10 years.

Not an Economic Necessity

Zynga deals in the sale of virtual goods and advertising on their video games. These items aren’t real and are for entertainment and amusement. This means that for most rational consumers the priority for money allocation in their personal budgets is low. When hard times hit, people are going to be more worried about buying food from the local Wal-Mart and life sustaining water bottled from the above mentioned Coca-Cola. In fact only 2% of the people who play Zynga games pay for any product at all. This leads to the next reason I think Zynga will be gone in 10 years.

The Whole World Has to Play

Zynga had roughly 300 million monthly active users for 6 months ending June 30. Of this number only 3.8 million people paid for a “virtual good.” These are the people who contributed to the $584 million dollar gaming revenue for the first 6 months in 2012 for Zynga. This is roughly 1% of the monthly active user base. In order for Zynga to gain any kind of prominence, the whole world will eventually have to play (see table below).

I think the wild scenario above is very unrealistic as you can probably imagine. I don’t think that Zynga could ever get the entire world to play its games. In the unlikely event that they do reach 100% worldwide penetration I don’t think they could get 2% of the world population to buy “virtual goods” (considering that only 1% of the current user base is). Achieving $300 per customer per year is a little unrealistic given the fact a number of countries have a population with lower per capita income than in the U.S., and the fact that Zynga is having a difficult time monetizing its mobile sites. The price of $45.09 represents a 69% increase per annum given they can achieve anything near the above numbers within 5 years. It is a mere fantasy.

Too Much Reliance on a Single Customer

Zynga receives roughly 87% of its revenue from a single customer: Facebook (NASDAQ: FB). Facebook is a company based on a fad as well. People go to Facebook to socialize, not to click on ads. As soon as people get tired of Facebook they will go on to something else. When Facebook’s fortunes dwindle, Zynga will go along with it. Facebook is another company that will be gone in 10 years.

Developing and Maintaining Online Games is Cash Intensive

People tire of video games and soon want something new to hold their attention. Developing new video games involves a great deal of research and development costs. Zynga’s research and development costs stood at $358 million for six months ending June 30. This is a 114% increase over the $168 million for the same time in 2011. Money spent for computers to host the games and buildings to house the aforementioned equipment and personnel to run them is no cheap task either. So far in 2012 Zynga has spent $234 million on a new corporate headquarters and had capital expenditures of roughly $78 million.

Questionable Accounting

There is some confusion on my part about Zynga’s accounting practices. Zynga recognizes revenue when the customer uses the prepaid product or when the virtual good has exceeded its estimated life. The latter criteria leave a great deal of room for subjectivity in recognizing revenue. Zynga says this is a non-GAAP measure but it is used in the discussion of the results of operations.

Future Difficulties in Monetizing Traffic

Zynga like Facebook is having increasing difficulty in monetizing mobile sites. Zynga is also anticipating lower monetization from foreign markets. This makes the scenario outlined in the above table even more unlikely.

Conclusion

It looks like Zynga is a house built on sand with quicksand underneath. Online video games are a luxury people can do without in hard times. The low number of paying users is an indication of the lack of willingness for the consumer base to purchase virtual goods. Having a customer whose business is a historical fad makes the future of this company even more questionable. The subjectivity involved in their financial reporting also makes me nervous. The challenge in monetizing mobile sites is a problem that plagues both Facebook and Zynga. For this reason I think Zynga and Facebook will be gone in 10 years and have put an underperform rating on Motley Fool Caps.

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