Zynga in the Doghouse

It's been a rough few weeks for Zynga: Its stock sank to below $3 a share (it started at $9.50 in December); it announced financial results that were well below what analysts expected, triggering shareholder lawsuits; and EA filed a copyright infringement lawsuit over The Ville's resemblance to The Sims Social. Zynga has reshuffled its executives and redoubled its efforts to improve its numbers. Now COO John Schappert has left, and apparently Mark Pincus is directly managing the company. Will it be enough? How deep are the problems, and how much ability does it have to fix them?

First, let's look at the problems. Zynga announced its second quarter earnings, and they came in well below expectations; Zynga earned one cent per share, where analysts were expecting six cents a share. Revenue was $332 million, coming in below the expect $344 million. As far as analysts are concerned, Zynga made a mess on the floor; analysts are busy using harsh words and stern tones to teach Zynga not to piddle on their earnings estimates again.

Arvind Bhatia of Sterne Agee was not kind. "While we have been bearish on the story since the beginning, these results and the current trends appear to be much worse than even we had anticipated. We do not share management's belief that these trends are temporary."

"While we have been bearish on the story since the beginning, these results and the current trends appear to be much worse than even we had anticipated. We do not share management's belief that these trends are temporary"

Arvind Bhatia

During the earnings call, Zynga execs attempted to explain the shortfall, citing three main reasons: Changes in the way Facebook does its notifications; later than expected launch of The Ville; and a sharp decline in Draw Something.

That doesn't tell the whole story, though. Average daily bookings per user declined 17 percent, even though monthly uniques grew. Some of this may be due to the mix of games changing, as many of its newer games are arcade games, which Zynga admits do not monetize as well as 'Ville style management games. Overall the trend seems to be that older games continue to lose players (along with the social game industry in general), and many of the newer games either don't monetize as well or just haven't been hits on the scale of the past.

What Zynga execs clearly wanted to say (but didn't for fear of offending Facebook) was that Facebook cost them a lot of money with their notification changes. These changes favored new games heavily and made older games much less visible. This struck Zynga's cash cows like FarmVille hard. It's not clear what changes Facebook may make in the future, and whether that will help or hurt. The uncertainty of the platform that Zynga depends on so heavily must be maddening. Of course, Zynga doesn't want to piss off the company where they derive over 80 percent of revenues, so they were always careful to couch their complaints in the most diplomatic way possible.

Zynga has other problems to worry about than just Facebook. Multiple law firms are investigating the circumstances of Zynga's second quarter shortfall, with an eye toward shareholder suits. These sorts of lawsuits are typical when a company reports unexpectedly poor earnings; add to that the secondary offering just as things were turning south and it would be surprising if we didn't see some shareholder suits. One more distraction for management at a time when they need all their focus.

Electronic Arts has filed a copyright suit against Zynga, claiming that The Ville infringes on EA's The Sims Social. This looks to be a lengthy courtroom battle, as EA certainly has the resources to fight (unlike small developers who felt that Zynga copied them, EA has plenty of money for lawyers). It's yet another executive distraction for Zynga, as well as more bad publicity to overcome.

"Zynga may have a host of problems to worry about, but it's also got an enviable set of advantages"

Zynga may have a host of problems to worry about, but it's also got an enviable set of advantages. Let's start with $1.6 billion in cash; that's a nice chunk of change that can fund many different initiatives. Even more important is a fact that seemed to have been passed over by many analysts: Zynga added $100 million to their cash hoard in the second quarter. So even when times were tough, and Zynga was not living up to expectations, they still tucked away $100 million in cash. They are not about to go away as long as they can keep doing that.

Zynga also has built a huge technical infrastructure to support its games worldwide, and this has proven to be eminently scalable to meet any sort of demand. It's also flexible enough to handle the demands of any type of game that Zynga may choose to do in the future. This is something few other companies possess.

Finally, and not least, Zynga has thousands of highly skilled employees, including some top design talent, with massive experience in all types of games. All together, this means that whatever strategic direction Zynga chooses it has the financial resources, the technical resources, and the talent all available to make it happen. The key question is, can Zynga pick the right strategy?

The big picture is really simple enough. Zynga parleyed its first-mover advantage in the social game market into a dominant position; it hitched itself to Facebook and grew explosively along with them. Zynga used its early advantage to go public and garner a stockpile of cash, along the way building a tech infrastructure to sustain games and support future growth. Now, however, the momentum in the social space and the game space has shifted to mobile, where both Facebook and Zynga are not cutting-edge.

The sheer newness of the business model that Zynga is using means increased risk. The overall slowdown in the social game market may signal that players are a little bored with the offerings, or are moving on to games on other platforms. Zynga has built a huge audience, but monetizes less than 2% of them. If the overall number of users isn't growing (which it isn't in social games), Zynga's options are clear. It can attempt to increase the percentage of payers; it can expand rapidly on mobile; it can substantially boost advertising revenue; it can get real-world gambling to be legal; or it can find large numbers of new players (for new games, or new countries for old games).

"Zynga has built a huge audience, but monetizes less than 2 percent of them"

Ad revenue delivered $41 million in Q2, up 170 percent over last year. That's an excellent rate of growth, but it's not the whole story. The question is scalability; if Zynga has to be involved in creating specific game tie-ins, as Pincus discussed in his interview, that is exciting for individual advertisers but not readily scalable. Google's AdWords is the ideal; advertisers can easily book ads with no human intervention, which is how Google has scaled it to tens of billions in revenue. Meanwhile, Zynga's ads displayed next to its Facebook games are advertising its other games; that's good for moving your audience to your other games, but it's not generating revenue.

Real-world gambling is going to happen for Zynga, as announced in its earnings call. It just won't happen in the US at this time, since the laws don't allow it yet. While Zynga lobbies for those changes to be made, it will gain experience with gambling in countries that do allow it. As more countries make it legal, Zynga will be able to take advantage of the experience. The potential market is in the billions of dollars, but how soon it will happen is anyone's guess.

Zynga recognizes the opportunity on mobile, and they are trying to get there; the $210 million spent on the OMGPOP acquisition shows how seriously Zynga takes the mobile market. Unfortunately, Draw Something turned out not to have legs; the audience has dropped significantly, and Zynga has been slow to build on the brand. In general, mobile games have been a tricky market, with the well-known deficiencies in mobile advertising making that avenue for monetization a difficult one. Acquisition costs have been rising, but that's one area where Zynga's scale gives it a massive advantage; it can funnel users from their existing audience into new mobile games. It just has to be able to monetize them better.

The real mobile problem for Zynga is a fundamental design issue. Smartphone screens aren't really big enough to make running a huge farm or a city work very well. Essentially, Zynga's best moneymakers, the Ville games, just aren't designed well for a small screen, even leaving aside the difficulties of porting Flash games to iOS and Android. Barring some clever interface design tricks, Zynga's going to have to look to other games or revenues in order to succeed on smartphones.

The huge opportunity, if it is achievable, is improvement in monetization. Pincus showed in his interview with GamesIndustry International that he's fully aware of the importance of moving that needle. "I really believe that the next great startup is going to be defined more because they invented a new reason for four percent of players to want to spend money in your game, and some of them to want to spend a hundred or two hundred dollars, than because they iterated on the bubble mechanic. We are working at that all the time. I feel like we've just scratched the surface."

Higher monetization levels have been achieved, but typically that's by games with a highly targeted audience; Kixeye's games are a good example. They monetize at multiples of Zynga's percentages (companies don't like to give out exact numbers), but they do by targeting hardcore gamers and having an audience that's an order of magnitude smaller than Zynga's audience (War Commander has 2.3 million MAU, compared to 35.5 million for Zynga Poker). The latest rumor is that Zynga may be working on a game targeted at core gamers; if so that represents a big strategy shift for them, but perhaps a critical one. Zynga declined to comment on this rumor, but it's certainly believable.

Fundamentally, people may just be tired of the same basic game mechanics of so many social games. The industry has seen many games from different companies with essentially similar game play, coated with different graphics. Perhaps this explains why the audiences seem to get bored faster and move away from the game. Copying games, or, more politely, 'fast-following', can be a successful business strategy, especially when a market is growing rapidly. Now it's biting them in the butt, as EA's lawsuit shows. Worse, the market of new users isn't growing, and the existing base is getting bored of a parade of games that have very similar core game mechanics.

"Zynga has to face the fact that it needs innovation now more than ever"

FarmVille 2 is a perfect example of where Zynga may be going off the rails. What's the point of FarmVille 2? Is the game somehow going to attract a new group of players? Perhaps, but it's difficult to see how it would unless the game play is very different... and then you'll lose the existing players. Is it about reducing the churn for current FarmVille players? Or perhaps increasing their willingness to pay? Those might be good reasons, but one would hope the cost of the revisions are in line with expectations of increased revenue. There is a danger here, too; will existing FarmVille players lose their carefully executed farms and their special items? If the look of everything has changed, and players are forced to migrate, some may not like having to change things on their farm. FarmVille 2 has to avoid the Mafia Wars 2 fiasco, and somehow bring the game back to the heady days of being the number one social game.

Zynga has to face the fact that it needs innovation now more than ever. It's time to let those 150 game designers off their leashes to roam free. Sure, they'll make a few messes on the sidewalk, but one of them just may catch a rabbit. Or, better, a very large whale. The Zynga Platform is also a good way to experiment, and Zynga needs to really open that up swiftly. Make it as transparent as possible, and easy for developers large or small to get onto it. Let the world know the specific deal terms, just as Apple lets you know how much they take when you sell a product in the App Store. Zynga should even be helping small developers bring their products to the Zynga Platform; create a development fund. Wild ideas can be tried with no risk to Zynga, and if they're successful Zynga can always buy the developers.

One of the key advantages - or is it a disadvantage? - is Zynga's ownership. Essentially, Mark Pincus has engineered it so that he is in complete control, with over 50 percent of the voting shares, as well as being chairman of the board and CEO. He has unquestioned authority to do whatever he feels necessary. If he's making the right choices, that's a good thing; Zynga will be able to move swiftly without waiting for internal politics to resolve before they can move forward. Of course, if he makes the wrong choices, there's no one who can stop him. In the end, it's up to Pincus to re-invent the company. He did successfully grow it from nothing to a market capitalization rivaling Electronic Arts, so there's good reason to believe he can come up with the right strategy. It may be difficult, though, to admit that ideas that worked brilliantly a couple of years ago may not work so well in today's market.

It's going to be a very interesting and challenging year for Zynga. The current $3 share price may either look like a real bargain twelve months from now, or it may be a fond memory. Investors, place your bets.