By Denis Hurley
Every day millions of people around the world purchase virtual seeds with a fictional currency in order to grow and harvest crops which are unable to provide sustenance to anyone - all from a computer or mobile device. Welcome to FarmVille. Along with many other well-known games such as CityVille and Mafia Wars, FarmVille is one of the most popular games created by the pioneering social gaming company Zynga.
Despite a highly anticipated IPO, shares of Zynga (ZNGA) performed poorly in their first day of public trading, reaching an intra-day high of $11.50 before dropping to $9.50 at the close. Uncertainties regarding the long term viability of the company's business model, the effectiveness of upper management (especially the manner and style of CEO Mark Pincus), and the questionable timing of the IPO, have dampened investor and analyst enthusiasm for the company, despite enviable historical growth numbers and financials. In the long run, however, this early leader in the niche social gaming market has enormous potential for expansion and offers a significant upside opportunity for investors.
The Games Begin
The San Francisco-based online gaming company was founded in July 2007 by current CEO Mark Pincus. A Wharton grad and Harvard MBA, Pincus' initial business ventures yielded mixed results but he achieved great success as an angel investor for several startup companies - including Facebook (FB). In May 2007, when Facebook invited outside companies to build applications for its social networking platform, he pounced on the opportunity to utilize Facebook as a platform for online gaming. Pincus initially dubbed his venture Presidio Media but changed the name to Zynga (after his late pet bulldog) in July 2007. Zynga released its first game for Facebook, Zynga Poker, in September of 2007 and its second, Mafia Wars, in mid-2008. Zynga's number of online users increased astronomically through 2008, a trend buttressed by Facebook's concurrent remarkable user growth.
Today, Zynga enjoys near total dominance of the social network-based gaming sector and continues to enjoy explosive growth in users and revenues. As of September 2011, it had more monthly active users than the next eight direct competitors on Facebook combined according to AppData. The company boasts over 230 million monthly active users and about 60 million daily active users from around the world (although most are in the United States).
Zynga's games are free to play and generate revenue primarily through the sale of virtual goods. In most games, users purchase virtual currency, such as Facebook Credits, with real dollars and exchange the currency for virtual goods and services - such as clothes for avatars or seeds in virtual farming games. In 2010, Zynga's average revenue per monthly average user was only $2.75, but the company earns its huge revenues by through volume, supported by a massive user base.
Zynga's historical financial numbers are impressive to say the least and analysts' lofty future estimates reflect its past success. Gross margins for past 12 months top 70%. The company carries zero debt. Total revenue jumped 106% from $401.7 million in the first three quarters of 2010 to $828.9 million in the same period of 2011. Revenues are projected to surpass $1.1 billion in fiscal 2011. Over the same period, gross profit leapt 117% from $277.3 million to $603 million. Unlike several similar IPOs of 2011, such as Pandora (P) and Groupon (GRPN), Zynga is already a profitable company, earning $30.7 million in the first three quarters of 2011 and $90.6 million in fiscal 2010.
However, the former number is down from $47.6 million in the first three quarters of 2010. Zynga is set to spend over $400 million on research and development and was sitting on a mountain of cash even before the IPO. Based on fiscal 2010 earnings numbers and the $10/share IPO price, which values the company at around $7 billion, Zynga has a price/earnings ratio of around 77. Such a high P/E sends value investors running for the hills, but for very high growth companies, this metric should not raise eyebrows. Unfortunately, Q4 2011 financial estimates appear increasingly poor due to a major expansion in R&D spending and a slight retreat in monthly active users.
Zynga outstrips its next eight competitors combined in a sector where achieving greater scale and a large user base is a self-reinforcing trend. In the social networking sphere, friends tend to follow friends. Zynga reaped a huge benefit by making itself the first mover in the sector and forcing its much smaller competitors to play catch up. Zynga's constant innovation and quick responses to changes in the social gaming market have knocked competitors back on their heels. Challenges from more traditional console and PC-based gaming companies, such as Electronic Arts (EA), face the same challenge - having to play catch up. As the first mover and quickly dominant company in the sector, Zynga sets the standard for social gaming and has momentum behind it.
In its Form 424B4 prospectus filing with the SEC in advance of its IPO, Zynga acknowledges that its gaming business model is almost entirely dependent on the Facebook platform and will be "for the foreseeable future". Any decision by Facebook to modify the terms of the agreement with external game developers, to organically develop competing games, or to favor another developer over Zynga, could devastate the business. Should Facebook lose its dominant position as the market leading social network, Zynga would suffer equally.
Under Zynga's current agreement with the juggernaut social network, only 70% of the value of Facebook Credits purchased by players for use in Zynga games is remitted to the company; Facebook collects the other 30% of the revenues. The relationship has proven to be unequally symbiotic; Zynga's very survival depends on the platform while Facebook simply reaps a portion of the revenue.
Zynga's owners structured its IPO in manner which allows long time investors and managers, particularly CEO Mark Pincus, to maintain control over the company's direction. One Class A share, which can be purchased publicly on NASDAQ, entitles its owner to one vote while a Class B share entitles its owner to 7 votes. One Class C share entitles its owner to 70 votes. Owners of Class B shares will control 72.5% of voting power and Pincus, as the sole owner of Class C shares will hold 25.7% of voting power. According to the company's prospectus, after the public offering, Mark Pincus will control 36.2% of voting power and upper management, including Pincus will control 47.6%.
Zynga's management team and corporate culture have quickly become infamous for their hostility, fierce inter-departmental competition, and aggressive pursuit of expansion and revenue. Pincus has no qualms about axing underperforming games and stalling projects. Employees have complained of poor treatment, long hours, hectic deadlines, and being bullied into accepting less valuable compensation packages, often with their jobs hanging in the balance. Perhaps the most infamous evidence of Pincus' cavalier attitude toward expansion is an excerpt from a speech of his:
So I funded [Zynga] 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 don't know, I downloaded it once and couldn't get rid of it. (Laughs) We did anything possible just to just get revenues so that we could grow and be a real business.
Nevertheless, it is difficult to fault management regarding results; Zynga is clearly very successful - as is its CEO. However, should management choose not alter its domineering style, it may put the long-term prospects of the company at risk.
The company's number of active monthly users is equal to less than 30% of total active Facebook users. A major advantage of Zynga's near total platform dependence of Facebook is access to a massive potential user base already interconnected by pre-existing "friend" relationships which can easily be transferred into social games. In addition, on October 11, 2011, Zynga announced its intention to create its own platform in order to reduce its dependence on Facebook, although details of the change were sparse and its success with users is an open question.
Another potential avenue for growth lies outside Zynga's principle platform in the realm of mobile devices. Gaming apps make it easier and more convenient to join and play outside of social network sites, although primarily mobile users may not spend a similar amount on premium features and virtual goods as their social network counterparts. In addition, the fact that such a small fraction of Zynga users actually contribute revenue to the firm's bottom line is both a vulnerability and an opportunity. The loss of some of these premium customers would have an outsize negative impact on financials but a conversion of some lite users into paying customers would have a similarly outsize positive impact.
Conclusion: Unique Risks but Also a Unique Opportunity
In its prospectus, the company acknowledges that its novel business model and the short history of the social gaming sector make it difficult to evaluate growth trends, changes in consumer tastes, future financials, and growth potential. Uncertainties regarding the company's business model, ability to respond to changes in the market and in consumer tastes, expand beyond its dependence on Facebook, and maintain its dominant position in the market through constant innovation and modernization, are very real risks to growth and shareholder value.
Finally, Zynga's lifeblood is its human capital. The company's internal innovation, flexibility, and responsiveness to changes in the market require the best and brightest employees and sound organization of talent. Management's aggressive style is a serious threat to the long term prospects of a company whose fortunes will ultimately be determined by its ability to attract and retain talent within an efficient organizational structure. However, unlike many recent IPOs, Zynga is already profitable company, with zero debt, substantial financial backing, popular products, and a vast pool of potential consumers.
The weak performance of Zynga shares in the company's NASDAQ debut may simply be a hiccup in its continued growth. A few quarters of stellar earnings and revenue numbers would quickly restore market confidence in Zynga's ability to continue to grow its user base, develop and refine its products at a rapid clip, and add shareholder value.