For Zynga, it's not game over yet

October 8, 2012: 7:21 AM ET

It's been a turbulent ride for the social game maker -- and things could very well get worse. But that doesn't mean the company doesn't have promising prospects, including a possible sale.

By Janet Morrissey, contributor

FORTUNE -- Zynga was on top of the world 18 months ago, courting Wall Street's crème-de-la-crème as it prepared to enter the public markets in one of the most highly anticipated IPOs in years. Venture capitalists, hedge funds, and even retail investors all scrambled for a piece of a company, which they were betting would deliver double-digit -- possibly even triple-digit -- returns. Those bets went up in smoke after going public as a flurry of missteps, missed earnings numbers, lawsuits, an exodus of senior executives, and other issues choked the company's growth and caused its shares to lose more than 70% of their value.

Things got even worse last week when it drastically reduced in its 2012 outlook. Now shell-shocked investors are wondering how Zynga (ZNGA), the company behind such popular social games as FarmVille and CityVille, can turn its troubles around, with some wondering if a sale might be the most likely path forward. Zynga's shares recently traded hands at $2.48 a share, a far cry from its all-time high of $15.91 set in March 2012 and IPO price of $10 in December 2011. "Does it make sense for some other company to look at Zynga? Definitely," says Atul Bagga, a senior analyst at Lazard Capital Management. "There are a lot of companies that could benefit with Zynga's expertise and credible platform."

Industry experts cite large media companies, wanting to branch into social gaming, and traditional gambling companies that want to expand into online poker, as possible suitors. Disney (DIS), for example, acquired social gaming developer Playdom in 2010 for $563.2 million plus an earn-out of up to $200 million. Analysts speculate other media companies may be looking at similar moves, and Zynga could be a good candidate.

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And gaming moguls, such as Las Vegas Sands and Wynn (WYNN), have made no secret of the fact that they're interested in expanding into online gaming if the Federal Government legalizes online poker. "One of the great assets Zynga has is their poker game and their large number of poker players," says Mike Vorhaus, president of Magid Advisors, a unit of strategic consulting firm Frank N. Magid Associates. Vorhaus notes that International Game Technology, which makes gaming equipment for casinos, moved into this segment earlier this year when it acquired rival social gaming company Double Down Interactive (which developed the Facebook's (FB) popular DoubleDown casino game) for about $500 million.

Still, it would take a company with deep pockets to buy Zynga today, despite the company's weak stock price. Zynga has a solid balance sheet, which includes more than $1.5 billion in cash, and has no debt issues or other pressures that could force it to sell in the near-term, other than frustrated shareholders. Even though Zynga missed quarterly earnings numbers in its first two quarters as a public company and slashed its 2012 EBITDA outlook in half, the company is still making money.

"They make free cash flow every month, so their cash is actually increasing, not decreasing," despite the weak quarterly results, notes Vorhaus. "They're not an unprofitable company." The free cash alone works out to about $1.65 a share, estimates Arvind Bhatia, a managing director at Sterne, Agee & Leach, and the company owns real estate on top of that. So, even using modest revenue multiples, analysts believe it's unlikely the company would accept an offer of less than the $10-a-share IPO price at this time. "If someone were to come in now [at the current pricing,] they would be trying to steal it, and it's not the CEO's job to help somebody steal the company," argues Vorhaus.

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Zynga founder and chief executive Mark Pincus holds 50.15% of the voting shares in the company and has indicated several times since the company's IPO that he has no interest in selling out. But analysts and shareholders say if the company is unable to execute on its growth plan and deliver solid quarterly results for at least two consecutive quarters over the next year, the company should field offers.

They would need to look at strategic alternatives says Colin Sebastian, senior research analyst at Robert W. Baird & Co., who recently upgraded the company to outperform on cautious optimism that the company can still turn itself around. "If the reason they don't want to sell is because they're under the impression they have a lot going on, then certainly we haven't seen it," says Bhatia. "If they're going to say no, they would have to have a good reason for it."

The company has had a stormy history since going public from missteps and other issues: quarterly earnings shortfalls, waning popularity for its FarmVille and CityVille games, the abrupt resignations of at least six senior executives since August, and concerns the company overpaid for its $200 million acquisition of OMGPOP -- a company whose "Draw Something" game began tanking in popularity after the purchase -- have all raised red flags for investors. There's also been a flurry of lawsuits, with at least six different law firms investigating concerns senior company executives, including Pincus, sold about $600 million in shares in early April -- before the lockup period expired and before the stock took a 50% nosedive. The suits also allege the company "misrepresented and/or failed to disclose materially adverse facts about its business and financial condition."

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Together, these issues have created an overhang on the stock and headwinds as the company tries to re-ignite growth. "We see the company and its stock treading water in the near-term," says Bhatia.

Zynga needs a catalyst to kickstart growth and its stock price. A hit game, preferably for mid-core rather than casual gamers, could be one such catalyst. Zynga recently launched new casual games, such as ChefVille and FarmVille 2. But mid-core games tend to attract more dedicated and loyal gamers who usually spend more time playing games -- and therefore can potentially generate more revenue than casual games. "They've kind of hit some saturation point and they need to diversify the style of games that they make," says Sebastian. Zynga has indicated an interest in moving into this niche as it recently acquired gaming studio "A Bit Lucky" which makes mid-core games.

Still, Zynga faces plenty of competition in the mid-core market from such seasoned firms as Electronic Arts (ERTS), and smaller firms, such as Kixeye, Kabam and Rumble Games. In fact, when news that senior executives were heading for the exits at Zynga, Kixeye put an ad on Youtube aimed at poaching Zynga's workers, stating "If you're a rockstar game maker and you don't want to put your talents toward cow clicking and virtual pet cudding, we might have a place for you..."

Other areas where Zynga could generate growth are through mobile gaming, its Zynga.com platform, and expansion of its online poker game internationally.

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Zynga's expansion into the mobile market and recent rollout of its Zynga.com platform are aimed at lessening its reliance on Facebook. Zynga received 87% of its revenue through the Facebook platform in the latest quarter. Bhatia says it's critical the company ramp up its mobile and zynga platforms before its deal with Facebook expires in May 2015. At that time, it's possible Facebook could alter the terms of its agreement with Zynga that could potentially lower Zynga's revenue share in the deal. Currently, Facebook gets 30% of the revenue Zynga gets through the sale of virtual goods on the Facebook platform.

"Zynga is making progress in mobile games," says Vorhaus. He says the mobile market is poised for potentially explosive growth over the next few years, as industry-wide, mobile gaming revenue is expected to hit $8 billion by 2015 from its current level of $2 billion, says Vorhaus.

Then there's Zynga's online poker game. If the US legalizes online poker, it could be a potential windfall for the company's Zynga Poker game in the real money gaming market. However, if no federal law is passed and poker is legalized on a state-by-state basis instead, the impact would not be as strong. "It means you could only have people in one state play with each other -- it becomes a much more fragmented business than it would with a federal solution," says Bagga. In the meantime, the company plans to expand the game internationally, where online poker is already legal. But even then, it won't be cakewalk as competition is intense in Europe.

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While all of these plans could generate growth and a possible turnaround in theory, the company will need to show it in quarterly earnings numbers to turn skeptical investors and analysts into believers. "They need to execute for a few quarters, show strong growth and plug the executive departures before investor sentiment turns positive on the shares," says Bagga.

Even the most patient analysts say they need to see such a turnaround in the next nine to 12 months. If this doesn't happen, they say, perhaps it would be time to actively look at strategic alternatives. Pincus "would be obligated to listen" to offers, says Vorhaus.

Pincus declined to comment for this story.

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