Zynga: Disappointment With Friends

| About: Zynga (ZNGA)

I picked up my iPhone today with a couple of minutes to kill. I tapped on the app icon for Words with Friends and I was disappointed that I didn't have any moves to make. It was not my turn on any of the games. This is not the only disappointment there would be involving Zynga (NASDAQ:ZNGA) this week.

On Wednesday, investors and traders watched for the press release that stated the earnings numbers that were set to arrive after the closing bell. Analysts were expecting revenues of $344.8 million with earnings per share anticipated to come in around $.06.

I didn't even need to see the report to know it was bad. The stock started plummeting in after-hours trading, and it was down 10% even before the link for the report appeared on my screen. I looked at the Q2 report, and it was worse than I had thought. The revenues came in at $332 million and the company had lost $22.8 million ($0.03 per share) for the second quarter. In a matter of minutes, the stock had fallen to the $3 level. The merciless beat-down had begun.

I thought to myself, how could this happen? How are they supposed to earn $0.26 for the year when they can't even turn increased revenue into a profit? I guess the leadership asked themselves the same question, because in the same report, it was announced that the guidance for 2012 had been lowered to an estimate of $.04-$.09. What were the problems?

Profits are becoming way too costly. Even if Zynga had spent all that it had intended to spend for the quarter, and all additional revenue would be 100% profit (unlikely with its track record), it would have needed a minimum of $354.8 in revenue just to break even. That is $10 million higher than the projected revenue and it still would have missed on the consensus EPS estimates. To just to meet the estimates, it would have needed a minimum revenue of $400 million. This tells me that the expenses were way too high. Even Electronic Arts (NASDAQ:EA) was able to turn $977 million in revenue into $0.17 in earnings per share in its last reported quarter. Only time will tell what its quarterly report will look like on July 31. This is not going to be an easy problem to fix, especially when they project a 50-60% tax rate on their earnings next quarter.

The quarter also showed a decrease in its optimism for Draw Something, the game it purchased from OMG Pop in May for $200 million. This was not a popular acquisition at the time, and it is beginning to look even worse now that the expectations have been lowered. I don't like the idea of purchasing companies that have up and coming games.

Not only are the profits coming at too much of a cost, but Facebook (NASDAQ:FB) user growth is slowing down and costs are rising. That is what we are seeing at Zynga as well. It is spending up the cash that was generated by the IPO, which is limiting the price protection that was once there. If Zynga continues to struggle to generate profits, it will no longer be able to remain debt-free.

With the current stock price of Zynga at $3 per share, and with the revenues growing at a healthy pace, I am afraid to begin a short position at this level. However, I am also fearful that management of Zynga never ceases to amaze me at how incompetent they can be. With the combination of these two factors, I suggest to stay as far away from Zynga's stock as you can. There are much better uses for your money as I have described in past articles such as Apple (NASDAQ:AAPL) and Baidu (NASDAQ:BIDU).

Disclosure: I am long AAPL, BIDU.