Is Zynga Worth The 13% Pop Since Last Week?

| About: Zynga (ZNGA)
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Zynga released its new Looney Tunes title, which was met with good initial consumer feedback.

The company continues to be too focused on casual games and the U.S. market which could threaten growth.

Zynga benefits from several key advantages as a large publisher, but needs to see the bigger opportunities available to it.

In December 2013, I started a games studio with three co-founders. I shut the studio down and gave the money back to the investors seven months later. There were many reasons for this, but part of the reason was that there was little to no appetite for VC money going into gaming startups in the U.S. Given Zynga's (NASDAQ:ZNGA) past few years and King's (BATS:KING) IPO, this is understandable.

That said, investment in gaming companies in Asia continues to go from strength to strength. Zhongji Holdings acquired Funplus this year for nearly $1 billion while companies like Nexon, Tencent (OTCPK:TCEHY) and NetEase (NASDAQ:NTES) continue to pump money into early-stage gaming companies. Ironically, Funplus, started by Andy Zain in 2010, was profitable by 2011 and actually built its business on the back of four games, one of which was strikingly similar to Zynga's Farmville.

I've been in gaming since 2005 and was part of Glu's (NASDAQ:GLUU) European management team when the company went public in 2007. Much has changed since then including the rise of iOS and Android and the decline of Nokia (NYSE:NOK) and BlackBerry (BBRY). More importantly, the death of carrier distribution and the rise of platform app stores completely changed the distribution landscape and democratized distribution for thousands of game developers. Now, instead of walking up the yellow brick road and begging the Wizard of Vodafone (NASDAQ:VOD) or Verizon (NYSE:VZ) to publish your games, you simply upload them to Google (NASDAQ:GOOG) (NASDAQ:GOOGL) Play and the App Store and hit publish (with the exception of China where you need to work with multiple local app stores like Tencent, Baidu (NASDAQ:BIDU) and others for Android).

Coupled with social media, offer walls, Facebook (NASDAQ:FB) ads, an overwhelming number of tracking/analytics solutions and some smart PR, you can build a decent business like never before. Better yet, with the advent of in-app billing, which allows developers to make their games free and only charge users for micro transactions, game developers removed a major barrier to entry which was the carriers' insistence on fixed price points.

All this is good and bad news for developers. It depends on which side of the fence you're on as a developer or as an investor.

But what does this mean if you're Zynga?

The good news is that games are not the risky investment they used to be. Many say that games are like the movie business in that they are hits driven. While that's certainly true for high-budget console games like Destiny, it's no longer completely the case for mobile. Mobile games and mobile games development have become much like software development overall and have now become more like Games-as-a-Service (GaaS for those who like interesting acronyms).

GaaS means that a games developer can develop a game, put it on one of the app stores and conduct extensive beta testing until they achieve or come close to achieving the monetization metrics they need to maximize the value of the game. This means that Zynga can generate a fair amount of valuable consumer data by launching a game in a limited number of markets, iterating on it and improving the games' features while holding back valuable marketing dollars until the game is fully tested and where it needs to be. Even once a game is launched, Zynga can continue to make tweaks and changes to the game over time, even introducing new levels, characters and items to keep retention rates high and reduce churn. Zynga certainly benefits from this model and as long as the games it makes aren't complete flops. Zynga can continue to iterate on them over time and improve their retention metrics even once the game is commercially live.

Zynga also benefits from its size and resources in several different ways. First, its position as a top developer gives it clout with the app stores. It's able to negotiate premium placement for its titles (much like Looney Tunes' featured visibility on Google Play currently), get access to early APIs from Apple (NASDAQ:AAPL) and Google and even get included in some of Google and Apple's marketing.

Second, its financial and human resources allows it to go much deeper into marketing than most smaller developers. Why is this important? Developers today have literally dozens if not hundreds of different sources of inventory to buy media from to promote their games. Each of these needs to be integrated, tested, tracked and measured. Larger companies like Zynga have entire User Acquisition (UA) teams dedicated to doing just this. For the smaller developer, every new source of inventory means integrating a new software development kit, testing their game, launching, measuring and tracking that source. Scaling to more than a dozen or so sources simply isn't achievable. For Zynga it still is.

More importantly, Zynga has the marketing firepower to get its games noticed. This is becoming more important given the overwhelming number of games available on both platforms. With merchandising space is so limited, the only way to get noticed is to use marketing and acquire users (unless your game is highly viral in which case you can rely on consumers to push the game for you - which is rare). The cost per install (CPI) to get users has also been rising as more developers compete for limited, high-quality inventory to get users. The effect here is to weed out smaller developers who have fewer resources and consolidate the power of larger developers like Zynga who have the firepower to acquire users over time. This kind of marketing power actually becomes a self-fulfilling prophecy since acquiring more users actually drives the game up the rankings, which generates more visibility and users generating more downloads.

Finally, Zynga has the advantage of localization and distribution. Gaming is a global business and in some markets consumers will not play games that are not adapted and/or localized for that market. The most obvious cases are markets like China, Japan, Korea or Russia. Zynga has both the resources to fully localize and adapt its titles if it wishes. It also has the distribution agreements to guarantee widespread distribution in those markets (this is particularly key in China, which has at least a dozen high-profile Android app stores that compete for consumers' attention, though Tencent is, by far, the largest).

So do all these advantages make Zynga a good investment?

Well, the answer is maybe. Though Zynga has many of the advantages listed above, it still needs the essential ingredient which matters most: a good product that monetizes well!

To this extent, last week's release of the Warner Brothers (WB) title Looney Tunes was a step in the right direction. Was it enough to warrant a 13% rise in the stock (as of Monday morning)? Sadly, no. Initial downloads, consumer reviews and a ranking in top free apps doesn't tell the whole story.

I spent a few hours playing the game and found it polished and fun and easy to play. Looney Tunes is a WB-themed endless runner game where consumers can play a variety of different characters like Bugs Bunny that run along a continuous stretch of road to collect coins, carrots and other items with the goal of trying to reach the characters' home at the end of the road. On the way, they need to leap over various obstacles, avoid classic enemy characters and accumulate a minimum number of special items. The games' graphics, controls and sound are all really smooth and the level design is well done and engaging. Also, as endless runner games go, they did a really good job keeping new levels fresh with new characters, special items and fresh gameplay. That said, here are the problems I have with it.

First, endless runner games are a pretty competitive genre with the likes of titles like Temple Run, Despicable Me and Subway Surfers being pretty established in that category. Though Looney Tunes gives it a fair run for its money and in many ways offers better gameplay and a stronger brand (with the exception of Despicable Me), endless runner games suffer from another problem: their gameplay and audience. These games, like most of Zynga's historical franchises, target casual gamers and though they have mass appeal (read installs/users), they monetize only a small percentage of their base: typically 1-2% of users. In addition, the average revenue per user (ARPU in industry terms) also tends to be fairly low.

Low monetization is the second issue I have with these particular types of games: the small percentage of consumers who pay implies a significant base of users is needed for the model to work. Of the three games mentioned above for example, only Subway Surfers even appears in the top 100 grossing games (the chart that really matters) on Google Play (#90 in the US). That's despite it having amassed in the range of 100-500M installs, which puts it as one of the most popular games among Android users.

The third issue I have with Zynga's choice of brand. Zynga chose to license Looney Tunes from Warner Brothers to develop the game. When I was part of the European launch committee at GLUU back in 2006-2008, we choose to avoid brands like this for Europe and EMEA because they didn't resonate well enough with international audiences. While Looney Tunes might be a decent, if slightly old brand, in the U.S., the international audience will be far smaller compared to a much stronger, more culturally relevant brand like Despicable Me.

In addition, since the title is licensed from WB, Zynga will likely be paying at least 15-20% of net revenues (after app store revenue share) to the license holder. Meaning that if Apple and Google take 30%, Zynga has lost 50% of revenue right off the top (before factoring in marketing costs) before they see any money at all. So essentially Zynga doesn't see margin benefits of having developed its own IP like a Subway Surfers, but also will limit its reach by using a weaker brand with less relevant appeal.

Don Mattrick's choice of licensed IP so far appears patchy at best. My fear as an investor is that exactly the same thing will happen when it releases Tiger Woods. Golf is a niche sport particularly in video games, which was one of the reasons Electronic Arts (NASDAQ:EA) discontinued the franchise on console (aside from how tarnished the Tiger Woods brand had become in recent years). That said, I launched Tiger Woods golf on mobile back in 2005 while at I-play and the genre lends itself really well to mobile though monetization is still a question mark for me. Can Zynga do better on mobile with it? I guess we'll have to see.

So where does that leave me in terms of Zynga?

The answer is cautiously optimistic. Clearly, the company has many of the advantages I listed above and the potential to make very good titles. However, to consider this as a serious investment, I would want to see three things:

  • First, a move to more hardcore games which involve higher, more sophisticated gameplay and development costs, but also require a far smaller, more engaged user base to monetize (since a higher % will monetize vs. casual titles).
  • Second, a focus on developing its own compelling IP, which can be built into stronger brands that are both more profitable, but also have the potential for brand extensions over time.
  • And, finally, a focus on developing games that will appeal to an international audience. With mobile games' growth slowing in the U.S., but still on fire in Asia, Zynga continues to be too U.S.-focused in my opinion in terms of the games it's making for mobile. Next year, the Chinese games market will surpass the U.S. in terms of size for mobile gaming. Japan is already 2x the size of the U.S. market for Google Play.

Zynga needs to wake up to the reality that it operates in a global market place and either find/develop brands that are more international in nature or develop studio capacity to develop additional games targeting large, key international markets (in the way that rival Gameloft (OTCPK:GLOFY) does). It's currently Beta testing its Empires and Allies franchise for mobile. Hopefully, this title can address some of these issues and give Zynga shareholders a real reason to celebrate a 10%-plus rise in the stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.