Zynga (ZNGA) may have a volatile year ahead as it goes through a significant transition and terminates some of its well-known games, to focus more on mid-core and real money gaming. In addition to this, the company's biggest opportunity lies in its gaming platform where it can act as a broker for game developers around the world. As expected, Zynga reported a sharp decline in its revenues during the first quarter of 2013, mainly due to lower number of new releases and the impact of reduced reliance on Facebook (FB). The second quarter will remain weak too as Poker bookings decline and Zynga closes down four of its games. However, the company remains confident about its ability to bounce back with its strategic initiatives that broadly imply greater focus on mobile gaming and further development of Zynga's own gaming platform.
Highlights of Q1 2013 Results
Zynga's revenues declined by about 18% compared to the the first quarter of 2012 due to lower number of monthly active users (MAU) and a decline in monetization. The company's overall MAU stood at 253 million down from 292 million for the same quarter last year. Even a sequential comparison showed a strong decline in these metrics as Zynga's previously successful franchises lost users. The competition in the social gaming market has increased substantially and Zynga's strained relations with Facebook aren't helping.
The silver lining is that Zynga saw healthy growth in its advertising revenues (which are still small) and "FarmVille 2" did well, increasing its bookings. In addition to this, the company saw increased user engagement driven by small gaming updates. Within a short time span since the launch of the Zynga account, about 3.5 million users signed up, which is encouraging from the point of view of Zynga's long-term strategy of creating its own gaming ecosystem.
Closing More Games in the Second Quarter
Zynga plans to shut down four of its games in the second quarter, including "The Ville," "Empires & Allies," "Dream Zoo" and "Zynga City" on Tencent. The company intends to direct its efforts and funds toward mid-core games, real money gaming and franchises that have demonstrated success in the recent quarters, including "FarmVille 2," "Draw Something," and the "With Friends" branded games.
Reduced Reliance on Facebook Will Continue to Hurt
The company mentioned in its recent earnings announcement that Q2 2013 will see a significant decline in bookings due to corrective actions by Zynga and Facebook, which essentially refers to Zynga reducing reliance on Facebook. The relationship between the two companies can be described as complicated at best. In a recent move, Zynga removed the requirement of Facebook login in order to access games on its own website. The move comes a year after the company launched its own platform for third-party game developers. Given Facebook's reach and user engagement, the straining relations can affect user activity on Zynga's games in the short term.
Approximately 45% of Zynga's value comes from its cash pool with another 30% coming from new and smaller games (other than "FarmVille," "CityVille," "CastleVille," "Empires & Allies," and "Texas HoldEm Poker"), according to our estimates. In other words, a significant portion of our price estimate relies on the expectation that Zynga will continue to launch successful games. One way to ensure this is by marketing third-party games, which is what the company has been doing for a while. Zynga's gaming platform could potentially become the default cloud gaming platform, thanks to the scalability and immense marketing reach it offers. In a recent conference, Zynga stated that one of its third-party games, "Village Life," has reached 1 million daily active users. A lot of times smaller game developers may have a compelling product, but not nearly enough marketing muscle. This is where Zynga can add value.
Long Term Strategy to Focus on Mid-Core and Real Money Gaming
Zynga has a substantial growth opportunity in mid-core games and online casino gaming. The company expects its mid-core games to keep users engaged for longer periods of time. A mid-core game tries to combine the engagement level of a core game with the learning curve of a casual game, to provide an engaging gaming experience to a larger user base. This can potentially allow for retention of a large user base, while promoting in-game purchases as the games are designed to be more engaging and users are likely to pay to upgrade, rather than drop off once the free-play scenarios are completed. Zynga recently launched "Battlezone," which marks its foray into action RPG (role playing game).
While investing in mid-core games might help, Zynga has much larger opportunity in real money gaming. The company recently rolled out real money games "ZyngaPlusPoker" and "ZyngaPlusCasino" in the U.K. The online gambling market outside the U.S. is worth more than $32 billion and Zynga can make a big difference to its business if it can tap this market successfully. However, the company will have to deal with the competition from gaming incumbents such as Caesars Entertainment, which already operates online gambling services in Europe and has bought social and mobile game maker Playtika.
Due to lack of federal legislation, gambling is being introduced state by state in the U.S., and Zynga has already applied for operator license in Nevada. The U.S. online gambling market can reach $7.4 billion in the next four to five years, and Zynga will strive to be one of the leading operators driving this growth. However, the company will have to compete against popular gaming providers and casino operators, who have significant mind share with gamers.
Our price estimate for Zynga at around $3.50, implying a premium of 10% against the market price.
Disclosure: No positions.