This is the second article in my three-part series analyzing Zynga (NASDAQ:ZNGA). In this article I evaluate the attractiveness of the market that Zynga competes in using Porter's Five Forces to ground my approach. Those five forces are:
- Threat of new competition
- Threat of substitute products
- Bargaining power of customers
- Bargaining power of suppliers
- Intensity of competitive rivalry
Ideally, a business would like to be in a market where there are high barriers to entry, few competitors, few substitute products, many suppliers, and limited rivalry between competitors. I'll go through each one of these forces and analyze the overall attractiveness of Zynga's market:
1. Threat of new competition (VERY HIGH) - The cost and time required to develop a social game is very low (single-digit millions and months) relative to the cost of developing a more traditional graphic-intense console game (tens of millions and years). This lower cost allows much smaller game developers to try their hand at developing the next big hit and has resulted in a proliferation of new competitors. Said another way, five guys in a garage you've never heard of could very well be the biggest threat to Zynga next year and there are a lot of garages out there.
2. Threat of substitute products (VERY HIGH) - Given the very rapid fall off in DAUs for even successful games-the half-life of DAUs from peak is only about 3qtrs for the best games-the firm must continually deliver new hit games or risk having users switch to other game developers. I try to be careful about reading too much into my own experience, but as a single data point, I tend to play a game on my iPhone for about 3 to 4 months until I stumble upon something new and stop playing the old game. And as a side note, I have no idea who makes 80% of the games I play, so have limited loyalty.
3. Bargaining power of customers (VERY HIGH/HIGH) - Zynga technically has two sets of customers: 1) its distribution partners and 2) its end-users. Currently, distribution of the firm's games flow through three primary channels and these gatekeepers have significant leverage in any future pricing discussions (particularly Facebook which controls between 80-90% of the firm's revenues). Zynga's current agreement with Facebook (NASDAQ:FB) expires in May 2015 and I would expect Facebook to push through a price increase. Said another way, Zynga needs them more than they need Zynga. As for the firm's end-user, some players are deeply invested in a particular game and in this case Zynga might have some pricing power (e.g. if you've worked for months building out your farm on FarmVille, you might shell out a few more bucks for a better virtual tractor), but for newer games pricing power is likely limited given the very large selection of free substitute games out there. Also if users begin to feel like they're being over-monetized in an existing game, the firm could potentially hurt its brand long-term, dramatically limiting the future uptake of its newer games.
4. Bargaining power of suppliers (VERY HIGH) - The firm's primary suppliers are essentially employees (i.e. game developers & their managers) and based on the cost management was willing to pay to attract senior staff and for talent-related acquisitions, the bargaining power would very much seem to be in the hands of the employees, not shareholders. Just to add some context, Jeff Schappert, ex-COO, who joined in 2011 was offered a $10mm signing bonus, a $10mm cash bonus vesting over 3 years, and shares valued at about $30mm on their grant date vesting over time. That's a $50mm compensation package (yes, spread out over time) for a non-founding COO at a $2.7b market cap firm. Mr. Schappert is no longer with the firm, but it's unclear what percentage of his original compensation package he is still entitled to. To add further insult to injury following a 40% correction in the stock, Zynga reportedly made new equity grants to employees to try and retain talent (article). Also considering the low barriers to entry, many of the industry's most talented developers will likely be inclined to start their own firm to reap a larger percentage of the rewards.
5. Intensity of competitive rivalry (VERY HIGH) - A quick flip through the available social games on any platform shows that there is a rampant epidemic of borrowed game themes. When I type 'Ville' into my iPhone app search, CityVille (Zynga's product) is the fourth option. The first three are My Town 2, City Story, and Design This Home, all variants on Zynga's 'Ville' franchise, which frankly is a variant on the original SimCity. These rivalries can get nasty too. For example, a Brazilian firm, vostu, was allegedly copying Zynga's games so closely it even inadvertently included the bugs. They eventually settled with Zynga once the lawyers got involved, but some of the damage was already done. There's also a great Pincus quote floating around out there, apparently he once said, " 'I don't f-----g want innovation. You're not smarter than your competitor. Just copy what they do and do it until you get their numbers.'" One final point, Zynga and EA are now suing each other for producing similar games. An industry with intense competitive rivalries between participants is often an industry where customers and lawyers are winners, but shareholders are not.
Porter's Five Forces Point To A Very Unattractive Market
Almost any way you cut it, the level of competition is extraordinarily high, the barriers to entry very low, and the sustainability of a leadership position seems questionable at best. Given that, I would expect most firms to struggle to maintain profitability. Zynga will make the case that their existing user-base, the social aspect of their games, and their dominance on the Facebook platform provides them with a sustainable competitive advantage, but I think it's only a matter of time before their dominance wanes. To the extent Zynga can create its own social footprint on Zynga.com, there might be some sustainability to their business, but I wouldn't bet the farm on the platform's success.
One final point, while I do believe Zynga's competes in a very unattractive market, I am not currently recommending investors take a short position in the stock as I believe the current market price reflects much of the downside risk. I estimate the firm has an intrinsic value of about $2.50 (or only 15% below the current market price).
As I mentioned up above this is the second article in a three-part series, a link to my first article is shown below:
As always, your comments and questions are appreciated below.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.