Why I Do Not Think Facebook Will Acquire Zynga ... Yet

| About: Zynga (ZNGA)

Look out below! Zynga (NASDAQ:ZNGA) shares are now down under $3.00 trading at $2.70, down an astounding 83% from their all time highs in March of $15.91. Now that ZNGA has completely tanked, we have been hearing rumors that Facebook (NASDAQ:FB) could acquire ZNGA in a takeover. Just because FB has the means to purchase ZNGA, and they are already so closely intertwined, doesn't mean they will, at least, not yet.

In fact this rumor is just that, a rumor, in my opinion. Much of the takeover talk is centered on the idea that FB's algorithm for displaying games has been modified to no longer feature ZNGA's games as prominently as they have in the past. Further, the rumor centers on the belief that this algorithm was employed intentionally to knock down share prices of ZNGA, so they would be willing to accept a takeover bid, and it would be cost effective for FB. There is some truth in this talk, in part, because FB confirmed such modifications to the gaming advertisement algorithm on the latest earnings conference call.

However, this change was done to highlight newer games. While this may have had some minor impact on ZNGA, it likely didn't have much, as the algorithm change occurred late in the second quarter, and ZNGA's web game popularity and revenues generated had been in free-fall before then, as evidenced in ZNGA's quarterly reports and conference call. Further, it may have been a catalyst for ZNGA; as such a change affects all gaming developers, such that ZNGA's newest games would be featured just as prominently as other developer's newest games. Many of ZNGA's newest players to games are also a result of cross promotion, as anyone who has ever played ZNGA games knows you are inundated with offers to try their newest games while you're in the middle of playing yours (maybe they could generate revenue by having you pay to turn off such annoyances, could be a real money maker). I think the idea that featuring new games as a headwind for ZNGA is overblown, and is only true if ZNGA is not innovating with new games that intrigue new players.

I also don't think there is truth to FB attempting to knock down ZNGA shares in an effort to buy them, because they are contracted to receive substantial portions of revenue generated from games played on the FB platform. In fact, FB generates about 14% of its own revenues from ZNGA. But the same revenue generation approach goes for all developers; FB charges a 30% flat fee for every transaction in game that occurs on their platform. Developers are constantly pumping out new games, because players become bored rather quickly with the same games. Thus, the key for ZNGA (and its competitors) is to innovate and design games people want to play, charging for things that make sense to pay for. The virtual goods business model is being questioned more and more. Further, many of these companies are turning to mobile gaming, which is why the street is so concerned with FB's ability to move to mobile and monetize it. It could be done through continued partnerships with gaming developers, rather than buying out ZNGA. Should FB buy ZNGA, wouldn't FB then be competing with themselves by allowing other developers onto their platform who are only paying the 30% fee? The other option is to not allow competitors on the FB platform to guarantee market share post takeover. But this would hurt FB subscriber choice and have other potential unforeseen consequences, in my opinion.

With such large revenues generated from these gaming companies on their own platform, it's a massive risk to buy out ZNGA and thus become responsible for the innovation. While it's possible, given FB's record of acquisitions, it makes more sense for the company to continue its partnerships over their platform while taking a fee, as they focus on moving into monetizing mobile, monetizing members (premium memberships?) and possibly competing with the likes of LinkedIn (NYSE:LNKD), which just reported another fascinating quarter.

Further, cheap can get cheaper. The stock of ZNGA is tainted, as investors seem to have no confidence in the company given insider selling and legal action being taken against ZNGA. An acquisition may be more likely, should the stock fall to $2.00. Hence my thesis, FB probably wouldn't buy ZNGA yet. However, it is important to note that ZNGA does become a real takeover prospect if they are able to achieve plans for real money gaming. That is, internet gambling. A lot of online poker players wager large sums of real money, and many internet poker companies are quite profitable. Should ZNGA be able to get international real money gambling off the ground, and they confirmed that this could happen in 2013, then FB or another large company (Apple (NASDAQ:AAPL) has the cash) might want to consider buying ZNGA, as some have suggested that real money gaming represents at least $1 billion in revenue opportunities for ZNGA. Given its current levels, this could double the value of the company.

As it stands now, the possible acquisition of ZNGA by FB appears to be just a rumor. The rumor has yet to spill into the stock of ZNGA, as it continues its bloodbath of a selloff. However, should the stock continue its selloff, and ZNGA makes good on its plan to move into real money gaming, particularly with mobile users, the stock itself could be a buy, as would the company. Time will tell if this thesis plays out.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.