6 Signs Zynga Is a Faker Breaker

You probably know what makes for a good Rule Breaker. Motley Fool co-founder David Gardner has six signs that specify the best of the best. We don't add a stock to the Motley Fool Rule Breakers scorecard if it doesn't meet the majority of these criteria. Those that fail go back to the coulda-been-a-contender bin. It's that simple -- and that difficult.

How so? What looks like a Breaker at first often fails to live up to the hype after getting its turn under the microscope. These "Faker Breakers," as we'll call them, are typically blessed with at least some outsized growth but lack the advantages of a leader capable of sustaining a premium valuation. Few stocks fit the mold as perfectly as Zynga (Nasdaq: ZNGA  ) .

Now you see it ... and now you don't
Numbers tell the story. IHS iSuppli reports that gamers now occupy just one quarter of Facebook's active user base, down from 50% in 2010. Growth could be tougher to come by unless the social gamer can figure out a way to diversify its user base. We've yet to see evidence that's possible.

Nor are Zynga's golden handcuffs as shiny as they might seem at first. IHS iSuppli's report comes in the wake of a poor fourth-quarter report that exacerbated fears of slowing sequential growth. Adjusted net income shrank 41% for the quarter and 37% for the full year, and that's despite massive revenue growth. Sales jumped 59% in Q4 and 91% for all of 2011. Higher operating costs ate the gains and then some.

Defenders will rightly counter that we often recommend unprofitable stocks in Rule Breakers. Core stock salesforce.com (NYSE: CRM  ) is likely to post losses all year while substantially growing the top line and signing large deals, just as it did in the fourth quarter.

Tesla Motors (Nasdaq: TSLA  ) also won't make a profit this year, and that's with the highly anticipated Model S sedan expected to reach market in July. Rick Munarriz, a colleague of mine on the Rule Breakers team, went so far as to buy from a Tesla competitor. If these stocks can make the cut, why can't Zynga? Because it possesses five of the six attributes of a Faker:

1. A late mover or copycat in an interesting but unimportant industry
Social gaming is interesting, but is it really disruptive? Not so far. I've seen many who have unplugged from social games for how much they interrupt everyday life or poison a perfectly good Facebook wall with "requests." Worse, Zynga is often criticized for copying smaller game developers in hopes of building a captive platform. There's little evidence of rebellious innovation here.

2. Unsustainable advantages disguised by outrageous growth
While Zynga has a history of triple-digit revenue growth, virtually all of that is due to its position as the leading developer of games for Facebook. Efforts to branch out beyond the social network have gone nowhere for the most part, with the mobile hit Words With Friends counted as an exception. Facebook, meanwhile, has incentive and interest in bringing more non-Zynga games to its platform. Electronic Arts' (Nasdaq: EA  ) The Sims Social is a good example, having already overtaken several Zynga games in terms of popularity.

3. Poor market returns
Zynga is up nicely since its IPO, but its $4.72 billion market cap is down spectacularly from earlier estimates that pegged the company's market value at north of $30 billion. Re-examinations and re-evaluations have led many -- rightly, I think -- to conclude that the business isn't worth as much as it was originally thought to be.

4. Bad management and lousy backing
Between copycatting and an unseemly, if admittedly small-scale, scandal in which CEO Mark Pincus and the board allegedly authorized equity clawbacks from some underperforming employees, there's good reason to question whether this team is capable of delivering outsized returns to shareholders.

5. Unimpressive consumer appeal
While Zynga is remarkably well known, a plurality and perhaps even a majority loathe the games and the company. Here's a sampling taken from Twitter recently.

6. Cheap according to financial experts
If there's one metric in which Zynga acts like a Breaker, it's in the valuation. Trading for roughly 37 times earnings and widely considered overvalued, it's tempting to call the company a rebel. Here's the problem: Expensive valuations are only good when they validate underlying strengths. Since we've already demonstrated that Zynga has noticeable weaknesses, its rich multiple is probably the result of hype, rather than legitimate admiration.

For these reasons and more I opened an underperform CAPS call on Zynga in January. What does an ideal Breaker look like? The Motley Fool recently tackled this question in a special report entitled, "Discover the Next Rule-Breaking Multibagger." The research is free, but only for a limited time. Click here to get your copy now.

Add Zynga to My Watchlist for up-to-the-minute Foolish coverage of the stock and your entire portfolio.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Salesforce.com at the time of publication. Check out Tim's web home, portfolio holdings, and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.

Motley Fool newsletter services have recommended buying shares of Salesforce.com and Tesla Motors. Motley Fool newsletter services have recommended shorting Salesforce.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 29, 2012, at 8:24 AM, steveat wrote:

    Response to

    1. 90% of rich people don't go out trying to re-invent the wheel. They'll just copy others...ie. Bill Gates and Steve Jobs. I would assume you know the history between those two.

    This may also give indication of lack of risk. A company that doesn't want to think outside the box, but then chooses to pick a conventional somewhat popular game and make it better...a la Bill Gates and Steve Jobs.

    2. Initial growth was a direct result of the brand awareness of Facebook. I don't think they were really ready for that size of growth and companies have growing pains.

    I don't think we have given them time to branch out from Facebook. I've learned that in business; become the best at what you are good at, then proceed to branch out, which they have done with their Bingo and mobile avenues. This expansion won't happen overnight and Zynga should start seeing potential by the end of the year. Branching out too fast is a result of lack of focus which will either stall company growth or impeded it.

    3. I agree, Market cap might be bloated, but it's stil a good company and definitely can achieve great heights.

    4. bad management or slave driver. I could tell you hundreds of successful companies run by a-holes. Sometimes stepping over people or being that proverbial dictator does the job. Andrew Carnegie was very similar. Read "Andrew Carnegie; The Rise of Big Business"

    5. You can't appeal to everyone. I personally can't stand turn-based games. I don't like Farmville or whatever, however, if they launched an interactive game...ie Texas Hold'em, which I do like, then I will play. I think the focus is too narrow, but that "narrow" is actually the majority. Zynga needs to branch out on the types of games they offer. This is where I think there may be a lack of imagination and probably it is due to Mark Pincus being a control freak. I know people like him..he is the final decision and while he will listen to you, he probably won't side with you.

    6. I am riding the hype until FB IPOs, then I'm out. I may buy back in when it dips again, but that remains to be seen.

  • Report this Comment On February 29, 2012, at 11:42 AM, TMFMileHigh wrote:

    @steveat,

    You lost me here:

    >>... 90% of rich people don't go out trying to re-invent the wheel. They'll just copy others...ie. Bill Gates and Steve Jobs. I would assume you know the history between those two.

    I do, but are you really suggesting that Mark Pincus is trying to execute a world-changing vision in the same manner those two did?

    Both spinach and money are green. Both are good for you in some way. So ... eating spinach will make me rich? Yay! (And ... eew.)

    Come on now. All reports point to Zynga copying games that get popular for the purpose of gutting them before they become a threat. That is *not* the same as drawing your inspiration from another's work.

    >>I could tell you hundreds of successful companies run by a-holes.

    But I don't know Pincus. I've no way to tell how nice or not nice he is or isn't. What matters is whether he possesses an authentic vision that's being well-executed. I see no evidence of the latter.

    >>I am riding the hype until FB IPOs, then I'm out. I may buy back in when it dips again, but that remains to be seen.

    My point precisely. Rule Breaker stocks needn't ride hype; they outperform because they're changing industries.

    FWIW and Foolish best,

    Tim

    --

    Tim Beyers

    TMFMileHigh, Motley Fool Rule Breakers Analyst

    Web: http://timbeyers.me

  • Report this Comment On March 01, 2012, at 2:55 PM, fridleymn wrote:

    I think social gaming is the future but I don't think Zynga or Facebook will be any part of it. They are just the last gasp of the traditional gaming industry.

    I see more people relying on their phones for gaming and I wonder if that is why Facebook's gamer numbers have been hit. Angry Birds is one example but I don't think we've seen the real breakout of smartphone gaming until we have something truly interactive that includes a social aspect.

    In ten years would you rather play "Farmville" on Facebook or pop open your phone and put on some 3D glasses and play Table Tennis with a coworker?

    I'd be interested to see if there was any correlation between the decrease of interest in Facebook games and a potential increase in interest in smartphone games.

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