Zynga: Pete Rose Vs. Mike Schmidt

| About: Zynga (ZNGA)

Judging by the title of my article it's probably obvious that I'm a Philadelphia Phillies fan who remembers the 1980s and the 1980 World Series team in particular. Mike Schmidt is a Hall of Fame player and a multiple gold glove third baseman but he was most famous for his 548 career home runs. Philly fans from that era also know he was famous for his hitless streaks and was booed by the fans on more than a few occasions for this. Even though he is remembered as one of the greatest players in team history he had a tumultuous relationship with fans during his career because of his inconsistent hitting. While his 548 home runs certainly places him among the top ever to play the game, his lifetime 267 batting average is mediocre at best and in my opinion hardly Hall of Fame worthy.

I was fairly young in the early 1980s and didn't know or care much about player reputations, my perception of players was based on what I saw them do night after night over the course of seasons. Pete Rose was not known for his home runs however he broke Ty Cobb's record for career hits and was one of the most consistent and clutch hitters I've ever seen play the game. He was my favorite player on those Philly teams because he produced almost every night and in my opinion provided more offensive production than Schmidt's once a week home runs, a disproportionate amount of which came in games that were already decided. In order to contrast the two players I go back to my honest visceral feelings when each came to the plate in clutch situations late in tight games. When Pete Rose came to the plate I expected him to make something happen. When Mike Schmidt came to the plate I prayed for the law of averages to kick in and this would be the time he finally came through in the clutch. This is also why he was booed often by the home team fans.

O.K., I know, enough already with the baseball history lessons, what does this have to do with Zynga (NASDAQ:ZNGA)? In my opinion the consensus about what this company needs to be in order to succeed is a home run hitter like Mike Schmidt when in reality they are likely building a consistent performer like Pete Rose. Here is a quote from a recent article to demonstrate my point:

It's been a long time since the Farmville days -- part of Zynga's brief tryst with originality. And now, its biggest acquisition to date is taking the flak as Draw Something's popularity chart shows a downward trend. While it's true that Draw Something was probably a good acquisition at the time, boasting of a record 50 million downloads within the initial 50 days of its launch, it's now facing the brunt of the fickle mentality of gamers so typical around the world.

While the author of the article may or may not have a valid point about whether Zynga overpaid for this particular acquisition, he seems to be suggesting that Zynga needs the most popular games in order to be successful. I'm going to try to show you how Zynga can be successful and more importantly investing in Zynga can be a success with just a steady supply of solid performing games. In fact I'll argue that they should and probably are intentionally spreading themselves out over a number of niche type games that can generate a more loyal following.

I'm not much of a gamer myself. I received a Play Station 2 a few years ago for Christmas along with three games. The first and only game I've ever played was a world War II game called Medal of Honor. I've never advanced beyond the newbie mode in the game because there were too many variables to control and I didn't have the time or patience to learn how to master all of this. I haven't played any Zynga games but my sister in law introduced my 6 year old daughter to Hidden Chronicles and they both love it and are addicted to it. My daughter asked me recently to play Medal of Honor with her but after a couple of minutes she gave up and left it to me to play the game because it was too complicated for her. The point being Zynga seems to have tapped into a different kind of more casual game player and again in my opinion is in the process of building a different kind of gaming business model.

Currently I count about a dozen featured games and Zynga has announced new titles to come. Skimming over Zynga's 2011 10K there was a sharp increase in R&D from ~$150M in 2010 to ~$727M in 2011. This suggests plenty of additional games and enhancements to existing games are in the pipeline. I see two reasons to be encouraged by this R&D push. First as I noted earlier I think there is a kind of moat to spreading the business out among lots of niche games if you will, with loyal followers. The second source of optimism has to do with the way they make money. Zynga has two sources of revenues, the first is getting subs to pay real money for rewards that enhance their game experience, the second is advertising money.

Right now according to their filings the bulk of their revenue comes from the player rewards with advertising only accounting for a small fraction of revenue. Online gaming accounted for $1,065,648 and advertising $74,542 for a total of $1,140,100 in revenues in 2011. Both getting players to pay for rewards and introducing ads into the games are new revenue generating models and each has plenty of room for improvement. In my opinion this evolutionary improvement is the key to success for Zynga and is the primary reason I've placed a wager on ZNGA recently.

While I haven't played the games and only have a rough idea how the two revenue systems "currently" work, I can come up with all kinds of ideas off the top of my head on how they could weave these things into games. For instance right now Draw Something is a kind of pictionary game that the author of the article I quoted thinks has run its course. Without having played the game here are some ideas I come up with for where Zynga can take this game to both expand it and better monetize it. They can work a sponsorship deal with Michael's and or other Art's and Craft's chains whereby gamers can browse online stores for tools like markers, paints, technical pens etc... that can not only be used for an upgraded version of Draw Something but also for regularly sponsored art competitions. The competitions would be based on the various online versions of the different mediums with regular, regional, state and national awards for different age groups. I don't think it's hard to imagine special advertising promotions based on medium preferences to get subs to try the real things that Zynga can get a piece of. Maybe Zynga offers a free low end version of various tools and charges for upgraded versions. Finally with a little bit of user information I can see working in targeted local ads related to the games like this local arts and crafts oriented museum.

That's just off the top of my head; I could come up with plenty more and would love to get paid if Mr. Pincus is lurking out there. In fact in my first draft of this article I used sports themed games where players purchase equipment from an online Dick's Sporting Goods Store as an example. In any case, right now they have only just begun to exploit these new revenue models, with only a tiny fraction of their subs accounting for their gaming revenues and advertising dollars hardly contributing at all. As I stated earlier I think this means plenty of room for improvement and with the R&D push going on right now I have hopes that ideas similar to the ones I came up with above are in the works to really monetize their sub base. This evolution of monetizing player rewards and advertising is where the money is at for Zynga and it doesn't require the hottest games. It only needs a stable of modestly popular games and some creative thinking.

They currently have ~3M out of ~200M subs opting to pay for rewards. I don't see why they can't get it up to 10M-20M with a little more creativity, experience and continued growth in the sub base. That would translate to something like a 3X-6X increase in gaming revenue and they would still only be tapping into 5%-10% of their base at best. My guess is the ad revenue is currently mostly from placements in the games. Maybe some creative interactive advertising like I noted above can get this to a more substantial number? If Facebook (NASDAQ:FB) is generating $4B a year in revenue from banner ads that no one ever looks at why can't Zynga generate a few billion a year in ad revenue, getting people who actually have an interest in products to actively look at advertising? I don't think it's far fetched to see gaming revenue going from ~$1B per year currently to say $4B-$5B/ year five years from now and ad revenue going from negligible to say $1B-$2B per year, maybe more. Say conservatively $5B per year in total revenues and maybe 3X-4X multiple on these revenues and you're looking at a $15B-$20B market cap company currently trading at a $4.5B market cap. Getting back to my Rose vs. Schmidt analogy, Zynga doesn't need home run games, they just need to up their average with more compelling paid gaming rewards and more creative advertising and some additional sub growth wouldn't hurt. This is not even including the development of their own platform that can save them a lot of money paying for Facebook's platform and make them money allowing third party developers to use it. None of this will result in a home run game but it will make the stock a home run.

Disclosure: I am long ZNGA.

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