social games

The problem with Zynga's growth

April 2, 2012: 10:43 AM ET

Zynga has a short but rich history of defying expectations -- including its stock price which is up. So why are people so bearish on the social gaming company?

By Kevin Kelleher, contributor

zyngaFORTUNE -- Zynga (ZNGA) has a short but rich history of defying expectations. Last summer, Zynga was expected to be worth as much as $20 billion as a public company. Turn out, it was worth $7 billion when it debuted in December at $10 a share. But a 5% drop on its first day led many to predict the stock would fare poorly. Not so: Zynga is trading some 37% higher since then.

So it's no surprise that views on Zynga are split. In recent weeks, analyst have issued mixed reports on the stock. PiperJaffray placed an "overweight" rating on the stock and a $16.50 target, citing its recent purchase of mobile game-maker OMGPOP for a reported $210 million. Wedbush Securities echoed that bullish opinion, encouraged that "Zynga remains well-positioned for long-term growth."

Others took a dimmer view. Needham & Co. put an "underperform" rating on Zynga's stock because of concerns such as "greater competition, user churn and slowing growth of Facebook's user base." Sterne Agee, which has a $7 target price for Zynga shares, wondered whether the revenues from OMGPOP's hit game Draw Something would be sustainable for long.

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Whether the acquisition of OMGPOP proves to be a shrewd bet or a risky one remains to be seen. AllThingsD cites sources as saying Draw Something is netting $250,000 a day after Apple's (AAPL) 30% take. That rate will buoy Zynga's financials for a quarter or two, but will likely decline after the next big mobile-game hit comes along.

What's more interesting about the OMGPOP deal is what it says about Zynga's growth strategy. CEO Mark Pincus is showing he isn't shy when it comes to buying companies that can produce gaming hits. In late 2010, it paid $53 million to buy Newtoy, whose Words With Friends has been a big title for Zynga. Last summer, according to the New York Times, Zynga bid $2.25 billion for Angry Birds maker Rovio (which said no thanks).

Such deals are necessary to ensure Zynga meets growth expectations. The OMGPOP deal came shortly after Draw Something displaced Words with Friends as the top-selling iPhone game in Apple's (AAPL) App Store – and a several weeks after Zynga said its non-GAAP income fell 41% during the fourth quarter.

MORE: Zynga breaks down share sale

But more importantly, an aggressive acquisition strategy could head off another long-term concern. The chronic problem with the gaming industry is one that also plagues Hollywood: You're only as good as your last hit. Consumer interest in-game titles comes and goes quickly, forcing companies like Electronic Arts (EA) and Activision (ATVI) to try to pump new life into older franchises or risk investing in new, unproven titles.

Zynga has succeeded with a number of big mobile titles like Farmville, which was followed by Cityville; and Mafia Wars, followed by Empires and Allies. But the purchases of OMGPOP and Newtoy signal that Zynga may be looking to do more than just buy the hit game of the moment. Instead, the company may be slowly building a network of social games that is tightly woven into the online friendships of its 240 million active users.

Draw Something and Words with Friends have more active users per day (12 million and 9 million, respectively) than other Zynga titles. Many of those loyal players use these games to interact with friends through Facebook or mobile phones, creating a network effect that is more powerful than other social games. Zynga encourages this interaction with features like instant messaging inside Words With Friends (and soon, Draw Something). Such features, Piper Jaffray noted, create a "social collision between play and communication."

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Once these sharing networks are in place, Zynga doesn't have to win over all of its active users, it only needs to win over a few, who then entice other friends to download and play the new games. Even when users tire of a particular game, they still have their group of friends who like online games, an audience that is more receptive to new games that Zynga introduces.

As encouraging as this scenario is for Zynga itself, it may not help investors. Because even as Zynga is making moves to keep its revenue and profit growing, it's also taking steps to limit the impact of that growth on its stock performance. In its IPO, Zynga sold 100 million shares, about 14% of its outstanding common stock. Last week, the company filed to sell nearly 50 million more shares in a secondary offering.

None of the money in the new offering will go toward Zynga's coffers – cash that could be used to make buy other innovative game startups. Instead it will pay out insiders like Pincus and early investors like Google (GOOG) and Union Square Ventures. Zynga shares have lost 11% of their value since Thursday, amid concerns that shares from the secondary offering will weigh down its price.

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And starting on May 29, the post-IPO lockup period will expire. Needham estimates that an additional 660 million shares could become available for sale in the next 12 months. Given the reports of a demanding workplace, and the mixed reviews Zynga receives from its employees, share sales by employees could be heavy. That selling could further dampen any gains Zynga's stock price would see from a strong financial performance.

So while Zynga is making bold moves to help ensure that it remains the most popular maker of social games, it's also making more of its shares available to the market. That's common enough in the year after a company goes public, but it will make it that much harder for outside investors to share in the company's future success.

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