Why Zynga Could Be Worth Every Penny

When Nintendo (OTC BB: NTDOY.PK) President Satoru Iwata warned in May of a coming schism that would alter the economics of console-game development, he was referring to developers who spend more time coding addictive smartphone apps such as Angry Birds. He wasn't directly calling out Zynga.

Maybe he should have.

Last week, the social gamer filed an S-1 chock-full of mouthwatering data. Revenue more than doubled in 2011's first quarter after nearly quintupling from 2009 to 2010. Cash flow improved more than 70% last year, while gross margin rose 18 points to 71% over the same period. This, Fool, is why the buzz has Zynga valued at roughly $20 billion.

And that's right now. If the stock follows the same trajectory as LinkedIn, Yandex, and Renren, the social gamer could close its first day of trading at a $30 billion or even $40 billion market cap, only to fall back to Earth within days. Such is the market for new social-media and cloud-computing names right now.

Building a different empire
What makes Zynga different is that there's a direct correlation between users and revenue. More than 96% of the company’s 2010 revenue, or $575 million, came from users purchasing something. In-game advertising accounted for the other 4%. Here's how Zynga describes the model in its S-1:

We operate our games as live services that allow players to play for free. Within these games, players can purchase virtual currency to obtain virtual goods to enhance their game-playing experience. Players can pay for our virtual currency using Facebook Credits when playing our games through the Facebook platform, and can use other payment methods such as credit cards or PayPal on other platforms. [Emphasis added.]

Your dream world awaits, Fool. All you need is $20 for the cover charge.

In many ways, Zynga is exactly like Electronic Arts (Nasdaq: ERTS  ) , Activision Blizzard (Nasdaq: ATVI  ) , and Take-Two Interactive (Nasdaq: TTWO  ) -- except the upfront game package is free and exists online. Add-ons drive revenue, which users crave in no small part because of the peer pressure inherent with social gaming. This isn't just genius at work. It's Dr. Evil one-meelliiionnn-dollars evil genius at work.

I know because I've been sucked in. Not only do I play Words With Friends with my eldest son, but I've also allowed one of my oldest and closest friends to dupe me into trying Zynga's latest, Empires  & Allies. As you can see from the photo, I'm finding it difficult to look away:

And yes, I've spent money in the game. Zynga offers me the option to buy upgrades directly through what it calls "empire points" in Empires & Allies (I bought in for $20) and through additional partnership deals, two of which I took advantage of: a discounted movie ticket ($7.50) and a magazine renewal ($18). The company has also tapped Groupon for localized offers. Apparently, enough of Zynga's 232 million monthly active users are buying in as well.

An unlikely edge
What Zynga has that EA, Activision, and Take-Two don't is Facebook. Or maybe it's the other way around. With the arrival of Google+ to the social-media circuit, what's to prevent users from fleeing Mark Zuckerberg's social network for the Big G's friendly confines? Video? Maybe. But I think games are more likely to provide the stickiness that Zuck wants.

Zynga keeps people engaged. According to AppData research cited in the prospectus, its games attract more monthly active users than the next 15 social-game developers combined. Sound like hyperbole? It does to me, too. Yet Zynga continues to push players to Facebook even though it has a website that could just as easily host games. It could also do more to put new games on iOS or Android and circumvent the 30% cut Facebook gets for using Facebook credits as in-game currency. But why change when the existing formula works so well?

Finally, consider engagement. Zuckerberg recently confirmed that Facebook has roughly 750 million active users, defined as those who've logged in at least once over a 30-day period. Of that number, it appears that 31% play FarmVille, CityVille, FrontierVille, Empires & Allies, or some other Zynga creation. Social gaming keeps Facebookers coming back. Again, again, and again.

Pricing an empire
As an investor, I love Zynga's options. Nowhere in the S-1 do I see language that prevents Zynga from seeking partners to expand its social-gaming ecosystem. Google+ may look more like a business network today, but what's to prevent Zynga from populating self-hosted games with Google+, LinkedIn, and Twitter users? Or how about creating localized versions for Renren, SINA, and others? Every online network is a potential target for Zynga's digital diversions.

And if you believe the research, the opportunity is huge. Zynga cites an In-Stat study that says last year's $7.3 billion in virtual-goods sales will more than double by 2014, resulting in 19% annualized market growth over the short term.

What happens longer-term? Listen to Iwata. His warning didn't refer to the next six months or the following three years. He was talking about a generational shift away from complex console games developed like movies -- and promising big margins as a result -- toward simpler, more social, and Web-friendly games we'd find hard to put down, no matter what device we're using to play.

Call me naive. Call me crazy. Heck, call me a Rule Breaker. Just don't call me timid, because I think this is exactly the sort of disruption you pay up for. Do you agree? Disagree? Weigh in using the comments box below. You can also email me here if you're desperate to feed my Empires & Allies addiction.

And if you care to learn more about the cloud-computing revolution, I encourage you to try this free video report. You'll walk away with a winning pick from our Motley Fool Rule Breakers scorecard and a better understanding of how the Web is reshaping entire industries. Watch the video -- it's 100% free.

Fool contributorTim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Check out Tim'sportfolio holdings andFoolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insightsdelivered directly to your RSS reader.

The Motley Fool owns shares of Activision Blizzard and Take-Two Interactive Software.Motley Fool newsletter services have recommended buying shares of Activision Blizzard, Take-Two Interactive Software, Nintendo, and SINA and creating a synthetic long position in Activision Blizzard. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.


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