This Tech Stock Isn't as Risky as It Seems

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.

Acquisition-happy
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."

BaZynga!
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.

Fool contributor Tamara Rutter owns shares of Zynga. Follow her on Twitter, where she uses the handle: @TamaraRutter, for more Foolish insight and investing advice. The Fool owns shares of and has written calls on Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Activision Blizzard. Motley Fool newsletter services have recommended creating a synthetic long position in Activision Blizzard. The Motley Fool has a disclosure policy

We Fools may not 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 (7) | Recommend This Article (2)

Comments from our Foolish Readers

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  • Report this Comment On April 30, 2012, at 3:10 PM, thesmartestfool wrote:

    Would be interested to see what you're basing the statement "Zynga has been poaching players from Activision's World of Warcraft for more than a year now."

    Rick's article failed to provide a viable source for that proposition.

    I don't disagree that WoW may be in decline, but I find it very hard to believe that the target markets for a fantasy MMO have significant overlap with the target market for games like "Words With Friends."

    Trying to draw comparisons between the two companies or stating that they share common target markets is comparing apples to oranges.

  • Report this Comment On May 01, 2012, at 12:04 PM, TMFSocialME wrote:

    Hi, [thesmartestfool] --

    Thanks for your comment. According to a report by McKinsey’s iConsumer Research, “A critical driver of penetration for social games is their lower cost to consumers, as most of them are free-to-play (FTP). The FTP model is quickly taking over traditional subscribers, even among hardcore games: core gamers are showing greater reluctance to pay for subscriptions driven in part by high prices and product stagnation.”

    I’m sorry for the confusion. I should have been more specific in my initial argument as to how the gamer segments overlap. While WoW has been able to sustain revenue up to this point, it’s quickly losing subscribers to the FTP model provided by Zynga and other casual gaming companies.

    The report goes on to say, “Perhaps in the clearest indication that subscription games might have had their day, Blizzard’s next big project is rumored to be free-to-play and more casual in nature, despite the company’s success in subscriptions with the WoW franchise.

  • Report this Comment On May 01, 2012, at 12:15 PM, CromulentBrad wrote:

    soooooo much competition in a field with almost zero barriers to entry. not only are they competing with other games, they're competing with movies, tv, websites, and a million other non-essential leisure activities.

    in today's ADD world, people get tired of the newest fad and move on to the next big thing in about 15 minutes.

    peter lynch would not be impressed and neither am i.

  • Report this Comment On May 01, 2012, at 12:48 PM, TMFBiggles wrote:

    @ Tamara -

    I don't know about the methodology behind that study. Does it actually survey current and former subscribers, or does it just look at Data Point A and Data Point B and try to draw a line between them? Rumors are clear indications?

    The way it's phrased seems like saying "This rock keeps tigers away. You don't see any tigers around, do you? Therefore, the rock works!"

    It's doubtless there is product stagnation. WoW came out in... 2004, I think it was. Most people get bored of the same MMO scene after so long. But that doesn't mean former raiders are suddenly saying "I'm tired of slaying this dragon every week, I'm going to play Farmville instead!" There's a vast chasm between Zynga games and WoW (as a former player of both), and the two models are more complementary than competitive in my view. You jump into WoW to kill a dragon, then when you're done you can tend crops for 5 minutes or so.

    Even if Blizzard does create a free to play MMO, that doesn't mean it's competing with Zynga. Its competition will still be EA's Star Wars MMO, Guild Wars 2, and whatever other similar games come out by the time Blizzard releases its next big MMO title. Many of those games (like Guild Wars 2) will be free to play, as MMO games were already transitioning a freemium model in response to WoW's lasting success.

    Hope that perspective helps somewhat.

    - Alex

  • Report this Comment On May 05, 2012, at 9:52 AM, thesmartestfool wrote:

    @ TMFSocialME

    Thanks for the response. The excerpt you provided on report by McKinsey’s iConsumer actually REINFORCES my initial comment. Note that it indicates that:

    "There are clear demographic differences relative to other game genres, however: players of casual games skew older (nearly half are 35 +years old, versus 31 percent for MMOG) and female (54 percent versus 34 percent for MMOG)."

    It continues on to say: "In fact, with the exception of the World of Warcraft juggernaut, most subscription games have not been able to sustain a healthy revenue stream, eventually converting to free-to-play. Perhaps in the clearest indication that subscription games might have had their day, Blizzard’s next big project is rumored to be free-to-play and more casual in nature, despite the company’s success in subscriptions with the WoW franchise."

    With all due respect - IT IS SIMPLY NOT ACCURATE TO SAY THAT ZYNGA IS POACHING PLAYERS FROM WORLD OF WARCRAFT.

    The demographics are different and ATVI has established a brand by delivering a quality product that no other developer has yet to match.

    I don't disagree that the FTP model is changing how large developers should monetize their products, but to say that Zynga is stealing significant share of gamers from companies like ATVI is not supported by facts. The demographics do not have any significant overlap.

    For Fools that want to read the report and make up there own minds, the link to the Mckinsey white paper is below:

    http://www.mckinsey.com/Search.aspx?q=white%20paper%20social...

  • Report this Comment On May 05, 2012, at 9:57 AM, thesmartestfool wrote:

    Also, please note that the McKinsey report states its OPINION that "subscription games MIGHT have had their day" on RUMORS that the next project will be free to play.

    Apologies for my use of "all caps"...its not intended to convey that I'm shouting, its meant to draw attention to those portions of my comments that I think need added attention, and since I can't bold or underline text in the comments section, use of "all caps" is the only way I can draw attention to those sections.

  • Report this Comment On May 21, 2012, at 10:54 AM, LoudJamie wrote:

    Sucks to have called ZNGA a "buy" less than a month ago.

    I agree that if you're looking for growth in ZNGA games, don't look at bored WoW players. We're a special breed. ;-)

    Wait for the FB fallout and total lack of enthusiasm from Wall St as they head for the Hamptons and pick some of this up in a speculation play during the quiet summer. Then unload before year end. That's how I think I'll play this game. ;-)

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