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.
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