Zynga Stock: This Bloodbath Is Deserved

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There are earnings misses, and then there are earnings disasters. With Zynga (Nasdaq: ZNGA  ) stock down as much as 40% in after-hours trading after releasing earnings, the company served up earnings that rank somewhere between the Hindenburg and the Titanic. Oh, the humanity!

I'm not surprised at Zynga's decline. In early June I advised, "don't buy [Zynga] at any price." However, I am surprised by the speed at which Zynga has fallen from grace. Let's take a look at what in Zynga's earnings spooked investors, and the broader long-term problems facing the company.

On the surface, Zynga's results don't seem so bad. Revenues were up sequentially and came in at $332 million. That's below analyst expectations of $343 million, but let's be real: A ton of companies have been missing this earnings season without seeing heavy losses.

However, the real pain comes not from what happened last quarter, but Zynga's future guidance. On the year, adjusted (you know, the overly rosy non-GAAP kind) earnings per share (EPS) are now expected to be in the $0.04 to $0.09 range. That's a pretty huge haircut from the $0.23 to $0.29 range offered just three months ago.

Oh, but it gets worse! Bookings, which is probably the strongest measure of Zynga's business direction, had previously been forecasted at a midpoint of $1.47 billion for the year. Now, with just half the year left, Zynga's guiding to $1.19 billion!

Generally, when companies are sold off in huge amounts after earnings, it's an overreaction. However, in the case of Zynga, investors are completely right to stampede over each other while rushing to the exits. Growth companies showing this level of deterioration are a bad bet, and the unsustainability of Zynga's business is starting to show.

The long-term worries
The problem with Zynga stock in the long term is pretty simple. It's almost entirely reliant on Facebook (Nasdaq: FB  ) as a platform for its games. The fact that Facebook is down almost 8% after hours on Zynga's earnings shows how intertwined the two companies are. However, as Facebook users increasingly shift to mobile, it reduces the viability of Facebook as a gaming platform. Instead, gaming shifts to mobile realms such as Apple's (Nasdaq: AAPL  ) iOS and Google's (Nasdaq: GOOG  ) Play store.

The problem for Zynga is that the company has very little presence in the mobile space and has failed in its early attempts to get serious traction. We've seen Zynga attract fewer mobile users on its tent-pole games like Farmville on mobile devices, and after buying Draw Something creator OMGPOP, daily active users of the game immediately went into a tailspin.

Video games are by nature a hit-driven business. However, video games on mobile are a hit-driven business on steroids. Falling off top sales charts can mean a quick plummet in sales, and tastes change quickly. That's not bad news for total spending on mobile gaming, and it has brought a tremendous amount of games to market. However, what it also does is level the playing field between small teams of developers and big video-game companies.

Think about it for a minute. If you want to create a game for Microsoft's (Nasdaq: MSFT  ) Xbox 360, there are huge upfront costs to develop that game and limited points of distribution. That is, you need maybe $20 million in resources to develop a game, and then the organization and distribution to get that game on limited store shelf space. It makes sense that huge companies would dominate this market. However, with mobile, everyone has the same access to resources. The most popular games are often developed by one-man shops and tastes are geared toward casual gaming rather than long epics like Grand Theft Auto.

That can still lead to huge success stories. We've seen Zynga come to dominate gaming on Facebook itself, and a company like Angry Birds creator Rovio has had reports of a valuation near $10 billion. Yet these success stories are proving far more fleeting. As I've noted before, while Mario was a dominant cultural figure and game seller for decades, it's unlikely Angry Birds will still rule the roost in 2032.

The end result of the shift to mobile is that the digital gaming market is exploding, but it's a highly diffuse market. That's great news for small developers, and awful news for investors of big gaming companies that relied on scale to dominate console areas or had first-mover advantages in platforms like Facebook.

The one bright spot today for Zynga investors actually came after earnings. On the post-earnings release conference call, Zynga tried to soothe investors' fears by announcing its intentions to enter the real-money gambling space. That's a move that's not wholly unexpected, and the belief that Zynga could see huge success in offshore gambling has been a key reason for Zynga bulls.

As was stated on Zynga's conference call:

"Finally, we are developing a new growth opportunity in real money gaming that builds on our strong casino presence with Zynga Poker, the world's largest free poker game and our new hits, Bingo and Slots. We expect to launch our first real money gaming products in international markets in the first half of 2013 subject to licensing approvals."

In the coming days, investors will have to weigh whether such a move could pay off for Zynga. Real-money gambling has largely been removed from America, so the growth areas will have to come from overseas. To me, this is Zynga's one real hope for enduring success. However, given speculating on overseas gambling success versus buying other great companies on sale right now, I'll choose the latter.

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Eric Bleeker owns shares of no companies listed above. The Motley Fool owns shares of Google, Apple, Facebook, and Microsoft. Motley Fool newsletter services have recommended buying shares of Apple, Google, and Microsoft and creating bull call spread positions in Microsoft and Apple. 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. The Motley Fool has a disclosure policy.

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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 July 25, 2012, at 7:51 PM, Magron wrote:

    They really don't have much of a product. As games, well, they aren't really in a traditional sense. There's little substance and nothing that people can really invest in. Unlike the well crafted major MMO games, Zynga's product is thin and easy to walk away from. The first rush of people coming in to look things over may be ending.. and not enough are staying.

  • Report this Comment On July 27, 2012, at 4:18 AM, dusty4444 wrote:

    I can honestly say that Zynga is a bad company and is managed by bad people. No appreciation to their customers and its all about taking your money. I spent close to $85,000 building a Mafia Wars account for myself and my family to play. Then one day Zynga just took our account away because they suspected activity that their "Terms of Service" said was not right. Yea all the money gone which my children and my self spent in a 3 year time period because Zynga SUSPECTED game play that they say was wrong.

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