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Online gaming company Zynga (NASDAQ:ZNGA) is expected to go public tomorrow, Friday, December 16th. The company will issue 100 million shares at a price between $8.50 and $10 per share for up to $1 billion in gross proceeds. With about 900 million shares outstanding, fully diluted post-IPO, Zynga's implied market capitalization will be about $9 billion. Is it really worth that much?

Zynga Is Not Growing

We have all read headlines like "Zynga Q3 Revenue Up 80% To $306.8M" (TechCrunch) and enthusiastic comments from founder and CEO Mark Pincus stating that Zynga's players create and store more than 35,000 virtual items every second and spend 2 billion minutes a day using Zynga's games. But if we look at the important metrics in the company's S-1 filing that includes the third quarter numbers, we get a very different picture.

The company's "bookings" - the dollar-amount of virtual goods sold to game players in the period - are essentially flat for the past three quarters. Zynga reported $287 million in "bookings" for the first quarter of 2011, down to $275 million in the second quarter, and back to $288 million in the third quarter. At the same time the company's "revenue" rose by more than 26% from $243 million in the first quarter to those $306.8 million quoted by the media. But this is potentially misleading, as Zynga's "revenue" is what it sold in the past 4-6 periods and amortized over the expected life of those virtual goods (quite a stretch, to be honest). Bottom line here: the actual money the company makes from selling virtual goods to its customers per quarter is flat for the past three periods.

You can read more about this on Business Insider, where the author concludes that "despite what you read, Zynga is NOT 'profitable.'"

The biggest concern for a company that is widely reported as "fast growing" is a declining user base. The most important metrics for measuring this are Daily Active Users (DAUs) and Monthly Active Users (MAUs), and if we look at Zynga's numbers from the S-1, we see that the trend for both these key metrics is negative:

Zynga reported an average of 54 million DAUs for the third quarter of 2011, 5 million less than in Q2, 8 million less than in Q1. And that number is down almost 20% from the peak of 67 million, reached in the first quarter of last year. Monthly Active Users are also down from all these periods, even though Zynga launched several new games (Empires & Allies, Adventure World, Mafia Wars 2, Castleville) this year. If we want to talk "growth" here, we have to call it negative growth.

Unhappy Customers

There are many reasons for Zynga's declining user base. Most of its new games have a very fast ramp to growth and reach their DAU peak at an early stage. But almost always this early success if followed by a dramatic mass exodus of players. Take "Empires and Allies" as an example that Zynga singles out in its IPO prospectus: "in June 2011, we launched Empires & Allies, a strategy combat game, which within its first month, became the second most played game on Facebook based on MAUs, as measured by AppData." If we look at AppData now, we find that the game peaked in early July at 53 million players (MAUs) and has since dropped to just 16.6 million. In other words, the game has lost almost 70% of its users in five months and the trend points to further losses.

You might think that Zynga would do anything in its power to keep as many users happy and interested in its new games for as long as possible. In reality, they are doing quite the opposite, which I would identify as the biggest problem going forward. Some of the decline can safely be attributed to a plethora of bugs in Zynga's games, and additionally to increasingly disastrous customer service. Those facts have not been widely reported yet, and the vast majority of investment advisors and financial analysts won't be hardcore gamers who can talk from their own game experience.

If we look at Zynga's official message boards we find most of the discussion dealing with game bugs for almost all of Zynga's games. There are currently more than 300,000 posts of angry and frustrated players in the bug reporting areas for "The Pioneer Trail" alone, which is one of Zynga's least successful games. On the board for Zynga's newest game, CastleVille, about half of the total posts are complaints about game bugs. At the time of writing, 30,362 out of 63,503 total were complaints, not counting those hidden in "Player Help" or "Feedback." If you read through those many messages, you will find that most of the game issues stay unresolved for several days or even weeks - often without any reaction from official Zynga personnel - eventually leading to many users to lose interest and quit the game.

In preparation for this article I have been testing Zynga's customer support. The company offers three options for player support: a toll-free phone number for U.S. customers only, a live chat option to talk directly to a customer agent, and an email support ticket system. As a non-U.S. resident I could not use the phone option, and the live chat has been unavailable for the past six days, with at least 100 attempts to reach it. My support request email from November 30 (for CityVille, Zynga's most successful game to date) triggered an automatic response stating that "We have received your support request and you should receive a reply within the next 48 hours." I have not heard back from them since, neither for the original request, nor for an additional one I sent them for another game (CastleVille).

Zynga's basically non-existent customer support - or maybe they are just understaffed and overwhelmed with requests regarding those myriads of game bugs - is likely another major reason for users abandoning its games.

The most appalling habit I've come across are unpredictable changes of game rules in complete disregard of the user's needs and playing styles. There is very little - if any - communication between Zynga and its user base regarding those changes, even if it makes the game almost unplayable for a large number of players, many of them paying customers. A very recent event is a change in population requirements for CityVille, the number one "hit game" in Zynga's portfolio. I won't go into detail here, but you can read all about it on currently 182 pages of complaints on the Zynga Community Forums.

Has Zynga lost touch with its customers, or maybe it doesn't really care at all? Let me remind you of a now famous quote from Mark Pincus back in 2009 when the company was just a little start-up and going public was a dream far ahead:

"I knew that I wanted to control my destiny, so I knew I needed revenues, right now. Like I needed revenues now. So I funded the company myself but I did every horrible thing in the book to just to get revenues right away. I mean we gave our users poker chips if they downloaded this zwinky toolbar which was like, I dont know, I downloaded it once and couldn't get rid of it. We did anything possible just to just get revenues so that we could grow and be a real business." (TechCrunch)

And now compare that to Mr. Pincus' evaluation of Zynga's corporate culture in a recent memo to employees (via Fortune's Term Sheet):

"We have nothing to hide in our past and present policies and I am proud of the ethical and fair way that we've built this company."

What if a large number of Zynga's own customers do not sign off on being treated in an "ethical and fair way" right now? Would that be a concern for investors?

The IPO price values Zynga at $8 billion to $10 billion, or roughly 7.5x its annual "bookings." The company is not growing at present, its user base is declining, its customers are increasingly unhappy, and the company didn't produce a major "hit game" since CityVille's launch in December 2010. The only thing that keeps up interest in the company is the industry it is in: social networking and gaming. Neither financials nor other business metrics support such a valuation, which led Stern Agee to start the stock with a SELL and $7 target even ahead of the company's IPO tomorrow. Such a pre-IPO call is a very unusual move in the industry.

Source: Zynga's Unhappy Customers