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When it comes to digital game maker Zynga (Nasdaq: ZNGA ) , it's easy to accept the bearish argument and move on. It is a new company with young leadership and a business model that the Street thinks is too reliant on Facebook -- case closed, right? Not so fast. I see more than a few reasons the stock will outperform down the road.
Let the games begin
Zynga reported first-quarter earnings last week that received mixed reviews from investors, despite posting better-than-expected results. Revenue rose 32% to $321 million in the period, marking its second quarter as a publicly traded company. While some called this a strong beat, others shook their heads in disapproval of increasing costs tied to equity compensation and a 160% climb in R&D spending. But where would Zynga be if it were underfunded in the area of research and development?
It certainly wouldn't be the world's leading developer of social and mobile games. I like that management is heavily investing in new titles. Zynga has introduced five new games since January, including two Web-based titles and four mobile. The company also added the game Draw Something to the score after acquiring OMGPOP last month -- giving the bears another reason to make noise.
At $180 million, Zynga paid a pretty penny to buy the mobile-game maker. However, Zynga CEO Mark Pincus defended the move, saying, "it was a rare instance for us." Rare seems like a stretch, considering the company also tallied $45.5 million in acquisition costs last year. The difference being that last year's figure counted toward 15 purchases. Still, I wouldn't be too quick to jump to conclusions.
In this dog-eat-dog industry, acquisitions are the name of the game. That's why Zynga needs popular app makers on its team if it plans to keep winning. This is a reality that traditional gaming companies understand, including Electronic Arts (NYSE: EA ) , which continues to pick up notable casual-game companies to better compete with Zynga. Last year, EA dished out $750 million to buy PopCap, and before that it spent $400 million acquiring PlayFish.
If Zynga can run with the big dogs, shouldn't it be allowed to make smart acquisitions like them? While it's too soon to tell, I don't think the American bulldog overpaid for OMGPOP. Zynga's playdate with OMGPOP gives it a necessary piece to the mobile puzzle. That's encouraging, considering most of Zynga's growth is coming from increased bookings in mobile games. Asked about the addition of Draw Something, Pincus said, "The game dramatically increases the size of our mobile network."
Larger competitors like Electronic Arts and Activision Blizzard (Nasdaq: ATVI ) will get a run for their money if Zynga stays on track. As my Foolish colleague Rick Munarriz points out, Zynga has been poaching players from Activision's World of Warcraft for more than a year now. Still, many investors don't know how to gauge an accurate valuation based on the free-to-play model, which is still in its infancy.
Bold as it may sound, I think Zynga holds the treasure map to monetizing user growth in mobile gaming. The company is on the right path, and with a bit of traction it should prove profitable for investors. In the near term, shares of Zynga will likely get a lift from Facebook's IPO next month. True, people are quick to point out the gamer's dependence on the social network for users. But let's not forget that Facebook needs Zynga, too, with 15% of Facebook's revenue coming from Zynga's business.
Shares of Zynga are nearing a 52-week low, but I think the market got this one wrong. I own shares and I'm reaffirming my CAPScall with a three-year outperform rating on the stock. At its current price, the stock is worth a second look for patient investors who can handle a bit of short-term volatility. If you prefer less risky investments, I encourage you to read this special free report from The Motley Fool: "3 Stocks That Will Help You Retire Rich." In it, you will discover three reliable stocks with market-beating performance already baked in. The free report also reveals helpful tips for building the perfect retirement portfolio.