Analysts Debate: Is Zynga a Top Stock or a Ticking Time Bomb?

The Motley Fool has been making successful stock picks for many years, but we don't always agree on what a great stock looks like. That's what makes us "motley", and it's one of our core values. We can disagree respectfully, as we often do. Investors do better when they share their knowledge.

In that spirit, we three Fools have banded together to find the market's best and worst stocks, which we'll rate on The Motley Fool's CAPS system as outperformers or underperformers. We'll be accountable for every pick based on the sum of our knowledge and the balance of our decisions. Today, we'll discuss Zynga (Nasdaq: ZNGA  ) , the online social-gaming company.

Zynga by the numbers
Zynga is still a relatively new company on the public market, completing its IPO this past December. Here's a quick snapshot of the company's most important numbers.

Statistic

Result (Most Recent Available)

Revenue $1,140 million
Net Income ($404.3 million)
2011 Stock Based Compensation $600.2 million
Market Cap $9.2 billion
Key Titles Farmville, Zynga Poker, Words With Friends, Draw Something
Users 240 million monthly active users
Key Competitors Electronic Arts (Nasdaq: EA  )
Activision Blizzard (Nasdaq: ATVI  )
Glu Mobile

Source: Zynga 2011 annual report.

Here's what we each think of the company's business model and prospects.

Travis' take
I must admit that the amount of revenue Zynga has been able to generate and the rate it has grown are both impressive. The company has also been able to continuously invent new games that keep users engaged. I just wonder how long it can last, since Zynga doesn't actually sell anything tangible and its competitive advantage is as fleeting as the whims of virtual gamers.

So far, Zynga hasn't faced a lot of competition from big players in the industry because they've been slow to react to the social-gaming scene. Electronic Arts, Activision, and Microsoft (Nasdaq: MSFT  ) have maintained focus on their big-ticket console games, but with Zynga's success, I doubt that will continue. Microsoft has Xbox Live on the iPad, opening gaming possibilities, and Electronic Arts is growing its presence in mobile games. Small developers may pose the biggest threat, as OMGPOP proved before Zynga wisely snapped up the company.

If you want a good reason to avoid Zynga, all you have to do is look at the company's SEC 10-k filing and check out the "Risk Factors" section, which is lengthy. One of the headings says, "There are low barriers to entry in the social game industry, and competition is intense." That means that two of the five forces in Porter's Five Forces are extremely weak for Zynga -- not a position I like my investments to be in.

I think Zynga will underperform the market, and a long Activision/short Zynga trade may be a good way to play the industry. A trade like this puts investors long a profitable, established company in the industry versus a young hot shot whose bubble may be about to burst.

Alex's take
Is Zynga a top stock? No. No, it is not. It is not an OK stock, either. It is a stock I would stay far, far away from.

I wanted to like it at first. I even played Empires and Allies on Facebook for a while. I had a lovely island full of crops and factories, with many complete strangers willing to click on my crops and factories to help them along. It was fun, for about a week. Then I maxed out, most of my loyal clickers got bored and stopped clicking, and I was left with a ton of wilted crops and idled factories. The few remaining loyal clickers whined plaintively about being blocked from spamming my Facebook wall with requests for fish or howitzers or something. I had to eliminate all traces of it.

This turns out to be a rather appropriate microcosm of Zynga as a company. It seems that much of the company's user growth happened very early in its existence. According to these graphs, the number of Zynga's daily and monthly active users have been flat to declining for almost two years, despite having taken less than three years to reach that peak. Compare that with Activision Blizzard's World of Warcraft, which and took a full four years to reach its highest subscriber count.

Zynga has launched several high-profile games in the past two years. Where are the new users? It seems likely that Zynga relies on those loyal clickers to keep its user base stable. Since so few of them actually buy anything, it becomes a bit like trying to squeeze oil out of a tapped well. In time, there won't be enough left to click on Zynga's crops. Profits may wilt! That may be why CEO Mark Pincus is already looking for an exit, filing to sell 15% of his shares less than half a year after going public.

Don't count on mobile gaming to save Zynga, either. Glu Mobile has never been profitable despite a stable of more than 50 mobile games -- offered "freemium," the same format Zynga prefers. Zynga's OMGPOP acquisition reeks of desperation to me, as that studio had no real success before Draw Something, and that game's already been displaced from its perch atop the App Store leaderboard. Is a one-hit wonder worth $200 million?

No, and I don't think Zynga's worth your money, either.

Sean's take
Zynga is social-media time bomb just waiting to go off, and, like the bomb squad, I'm running in the opposite direction. Despite rapid sales growth and the popularity of its Facebook-based games, Farmville and Mafia Wars, there are far too many weaknesses that could topple Zynga.

For starters, to echo Travis, the barrier to entry into social gaming is incredibly low, while the research costs associated with new games is incredibly high. According to Electronic Arts vice president Jeff Brown, video-game development costs could rise 200% for the next-generation consoles (which, may I add, are right around the corner). Between the added competition on Facebook from EA and rising development costs, I don't see Zynga maintaining its torrid growth pace.

That leads me to my second key point: Zynga's slowing growth. If you look past the initial 91% pop in year-over-year revenue from 2010, you'd see a rapid decline in sequential revenue growth from 15% in Q1 leading to Q2, to 10% into Q3, and just a paltry 1.4% sequential growth in the fourth quarter. To me, it looks as if Zynga's days of high-growth are already gone.

Finally, we have Zynga's brutally lopsided revenue stream, which relies on Facebook for about 90% of its revenue and Google (Nasdaq: GOOG  ) for another 5%, approximately. Facebook wields far too much control over Zynga's financial well-being for my liking. It also doesn't help that, of Zynga's 240 million gaming members, less than 3% of them are paying customers.

With numbers like these, I'm not quite sure how anyone would be excited to own Zynga. I'm almost tempted to call the bomb squad and give them advance warning of what I think is an impending disaster.

The final call
The group is unanimous (for once). None of us is a fan of Zynga, and we will add an underperform CAPScall on the stock on our YoungGuns CAPS page. Zynga may not be an analyst's top pick, but there is one stock that The Motley Fool has called its top stock of 2012. Find out what it is in the free report here.

Fool contributors Travis Hoium, Alex Planes, and Sean Williams have no positions in any companies mentioned. You can follow Travis on Twitter at @FlushDrawFool, Sean at @TMFUltraLong, and Alex at @TMFBiggles.

The Motley Fool owns shares of Activision Blizzard and Microsoft and has written calls on Activision Blizzard. Motley Fool newsletter serviceshave recommended buying shares of Microsoft and Activision Blizzard, creating a synthetic long position in Activision Blizzard, and creating a bull call spread position in Microsoft. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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

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 April 05, 2012, at 6:51 PM, Jayrozz wrote:

    Guys I really appreciate the analysis but please for heavens sake you didn't even BEGIN to mention the utmost important aspect of Zynga. ONLINE GAMBLING. You can't even sit here and debate whether or not it will be legal because IT WILL. Zynga is so perfectly positioned with zynga poker to DOMINATE the mobile gambling space and will bring in more revenue than you could ever think it to. Please I beg you to look into these possibilities before you "run" away for the stock. It will cost you a chance to make big money.

  • Report this Comment On April 05, 2012, at 6:53 PM, Jayrozz wrote:

    I do agree with the low barriers to entry BUT it's got the brand name boys and we all know how powerful a brand name can be.

  • Report this Comment On April 06, 2012, at 6:39 PM, TMFFlushDraw wrote:

    @Jayrozz

    I follow gaming, played poker online before PokerStars and Full Tilt went dark, play Zynga Poker, and I understand your point, but disagree. The casinos will push into the online gaming space hard if it's legalized, offering benefits that Zynga can't, online specialists like Party Poker will also hit the market hard. Zynga may play a roll, but I see it as small and I'm not sure they have the expertise to navigate the potential regulatory environment. It's easy to say they'll dominate online gaming, it's something else entirely to make it happen.

    Legalization is also not immanent. I doubt it happens before the election and who knows what happens after that.

    Just my thoughts,

    Travis Hoium

  • Report this Comment On April 06, 2012, at 10:17 PM, AcapulcoKevin wrote:

    I don't think Zynga or any online pay for play games like Zynga should be trusted by anyone. Players or Investors.

    I only play Zynga poker and I can show you posts on my Facebook wall for 1st place trophies, game after game. Then they needed cash in the bank and now I can't win a game on 4 Aces. They want me to buy more chips.

    There is no one regulating these games to make certain the income they are receiving is not coming from rigged games. Zynga poker is their cash cow.

    Enron had a similar mission statement regarding trust, honesty, integrity and look where that went. Hey trust us, just because? Gonna dump my stock before shite hits the fan say all the insiders.

    I think trusting these companies is a bad move.

    I would wait until there is strict oversight, code inspection and intense scrutiny before risking a dime in this company or those like it.

    Online scams are rampant and online games fall under that category. Flash games are not hard to create and stacking the deck in favor of the house is very easy to accomplish.

    Ultimately these companies have no tangible product to sell and you are gambling on air, a promise and a prayer that they are honest.

    I strongly believe that if many of the games available through Facebook were closely inspected many would fail the scam test.

    Is it worth the risk?

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