A Financial House of Cards?
Rahul 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) has underperformed the stock market significantly as it has lost around 67% YTD. While some investors believe that the stock has reached rock bottom, we expect further downside may be well in place. We are concerned with the weaknesses in Zynga’s business model which doesn’t strike us as sustainable like Google (NASDAQ: GOOG) or Amazon, which offer services that we cannot live without. It offers games as a service to its users who are normally teenagers with little to spend and an overly unpredictable nature to switch to the next big title. Adding to the woes is the fact that Zynga is overly reliant on Facebook (NASDAQ: FB), which again has a rather inconsistent business model with its low Click through rates and its users getting increasingly bored.
Over the past several decades gaming has transitioned from PC to consoles to social Web and now to mobile. We believe that the high growth in mobile gaming will reduce ZNGA's monetization potential. While Zynga has pretty solid social-gaming roots with its Facebook presence, we believe that the future of gaming lies in mobile devices where the ability to pay for in-app purchasing is limited at this time. Although Zynga currently sells mobile games, we believe that the availability of free titles will vastly limit the company's ability to monetize mobile.
While Zynga’s business model offers significant operating leverage if the company can increase the monthly active payers, the company will still need to continue investing in R&D to develop new games. We believe that Zynga will need huge cash inflows if it wants to stand up against competitors with the stature of Electronic Arts and Activision Blizzard, both of which have a much higher market cap than Zynga. Though the Ville series has brought plenty of revenues to the company, we believe that users are finally getting bored with Ville titles and Zynga needs some new arrows in its quiver now if it wants to perform a turnaround. While increasing expenditure in R&D is a risk that Zynga will have to take if it wants to maintain its position in the gaming sector, we believe that it would result in lower operating margins for Zynga which could further cause downside in the short term.
Another big reason that adds to our worries is the continuous cash burn Zynga will have to face due to the short product cycles in the gaming industry. We believe that in the social gaming industry, this effect is even more pronounced as a network of friends can move together between titles resulting in a considerable loss in MAU if the companies don’t innovate. Further, we believe that as Zynga releases new games, current titles might be cannibalized by newer titles. Looking at the history of popular games on Zynga, we note that when a certain game has a DAU drop-off, it generally loses all its value for Zynga as it has never achieved the peak levels again. For example Farmville achieved its peak at ~28 million DAUs and nine months later was at ~4 million DAUs.
As Google has recently changed its “I am Feeling Lucky” button interface, it has provided a fun way to direct users to its Google+ game site, where it has plenty of games lined up. With Zynga’s low presence in the Google+ ecosystem (we could not find CityVille and FarmVille, Zynga’s two flag bearers on Google+) and a potential risk of Google+ gaining traction at the cost of Zynga’s main user platform Facebook, we believe that Zynga faces further woes going forward.
Adding to the concern is Zynga’s inability to stop technical talents leaving the sinking ship as Zynga’s Chief Technology Officer Laurent Desegur was poached by a start-up named GameClosure. We believe that Zynga may face a hard time in attracting talented developers and keeping them on board. Furthermore, we believe that in a time of economic slowdown, Zynga will be the most likely victim as the users stop spending money on virtual gaming goods to buy actual goods. With the low barriers to entry and the minimum platform requirements to design a game, we consider Zynga as a very fickle company. We can’t know what the future holds for Zynga, but we won’t be surprised to see if any other company overtakes Zynga on the Facebook battlefield. As we believe that the stock has plenty of risks going forward, we rate Zynga as a sell.
Know What You Own
Zynga's post-IPO performance has been dreadful, and investors are beginning to wonder if it's game-over for this newly public company. Being so closely related to the world's largest social network can be a blessing and a curse at the same time. You can learn everything you need to know about this company and whether they're a buy or a sell in The Motley Fool’s new premium research report. Don't even think about picking up shares before you read what our top analysts have to say about Zynga. Click here to access your copy.
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