Zynga Games: Where Is It Going?

| About: Zynga (ZNGA)

Let me start this piece with a damning admission: I do love me some Mafia Wars, and I am guilty of barraging my friends with Words with Friends requests. But no matter how much I love these games, I have no love lost for their creator, Zynga Games (NASDAQ:ZNGA). Before Facebook (NASDAQ:FB) got the dubious title of launching the world's most disappointing IPO, there was Zynga. Remember Zynga? The company made its IPO with much fanfare in December last year, pricing its shares at $10 a pop and raising $1 billion. However, the stock fizzled out on the very first day, casting doubts about the share valuation and the robustness of the company's business model. And if you thought its first day was bad, then you were in for a nasty surprise. Since then, Zynga stock has nosedived sharply and is currently trading below the $3 mark.

So what exactly went wrong with the poster child of new-era games? The very first thing that comes to mind is "Irrational Exuberance." The stock was priced at the higher end of its band, and the entire company was valued at about $7 billion to $8 billion. This valuation made Zynga twice as big as its competitor, Electronic Arts Inc. (NASDAQ:EA), which commands a market capitalization at $4.04 billion. You can sense something is not quite right when a new company with no credible track record is valued higher than a industry veteran with a stellar history. Not to mention the fact that Zynga's fortunes depend on the less traveled road of social gaming, a niche that has yet to prove its potential for monetization. While Zynga may have sold a million bales of virtual hay, its ability to actually monetize these virtual goods should have been valued conservatively. However, "hype" is the name of the game in stock markets -- until it goes south, and you lose the game.

Zynga had sketchy financial statements even before its IPO. The company is still earning negative net income, though it has been able to stem the losses. Negative net income is steadily decreasing from December 2011. Explaining why would require another whole article, but in short, Zynga is a growing company that is introducing new products, which is helping it to pare its losses.

Zynga pioneered the concept of social gaming, but these games lack the cult appeal of more sophisticated games like World of Warcraft, Final Fantasy, et al. The target demographic for social games is also less likely to spend real money on buying virtual goods, which poses a big threat to the company's revenue generation capacity. Recent reports are also suggesting social gaming fatigue, which also does not bode well for Zynga.

Startups like Zynga derive their value from their human capital, and the company is not doing well on this front, either. Its top performers have been leaving in droves. The most recent departure was Allan Leinwand, the company's chief technology officer. Zynga has already lost at least seven senior executives, including Bill Mooney, the brains behind the FarmVille franchise.

Is it all gloomy for Zynga? The picture may look bleak, but the company is doing what it can to stay in the game, so to speak. Its future depends on churning out popular game titles. While it may be doing so organically, it is not hesitant to use funds to acquire its rivals to gain a competitive advantage.

For instance, the company bought OMGPOP for $200 million, adding titles like Draw Something to its portfolio. Draw Something has seen its user base decline since then, but Zynga is still optimistic about long-term synergies. At the very least, it expects the acquisition to help it make an inroad into the mobile gaming segment and reduce its dependency on Facebook. The social gaming company also has a relatively comfortable liquidity and enough resources to make acquisitions to fuel its growth. It is also moving beyond social gaming, selling virtual goods. Initially, Zynga was not focused on selling virtual goods like farming equipment, firearms, etc. through its games like FarmVille and Mafia Wars. Now, it is constantly increasing the variety of goods available through in-game purchases. The impact on the company's bottom line is simple, as pedaling virtual goods provides an additional revenue stream over and above advertising revenue.

Additionally, Zynga is said to be lobbying for real-money online gambling. This type of gaming is still a gray area in the U.S. As such, the company's initial planned target is the international market. Zynga is planning to launch its new endeavor by the first half of 2013. This venture is one of the most crucial tests of the company's survival. Not only will the successful execution of the project help Zynga pump up its monetary resources, but it will also help the company venture into international markets that may offer more accepting environments for online gambling.

Zynga stock is down more than 70 percent from its IPO price. So, is it time to invest in the company? With no concrete plans from Zynga, I would stay away from the stock until management comes up with more substantial monetization plans. I would certainly need more reasons to go against the verdict of analysts from Evercore Partners and Jefferies, who have rated the stock Underweight and Hold, respectively. However, if you are already stuck with this stock, then you can take solace in the fact that you still did better than the venture capitalists who invested in the company at a $14 per share valuation in early 2011.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.