Why You Should Avoid This Social Media Company

Do you remember when Zynga (NASDAQ: ZNGA  ) dominated the Facebook (NASDAQ: FB  ) experience with Farmville and Mafia Wars requests? It wasn't that long ago. Zynga was the star of many Facebook pages, at least until its December 2011 IPO. What happened in just two short years?

The peak and fall
In 2011, a whopping 12% of Facebook's entire revenue was just from Zynga; that year, Zynga itself generated $1.14 billion. It dwindled to 9% for fiscal year 2012, 7% for third quarter 2012, and this year it is so low and irrelevant that Facebook quit mentioning Zynga in its 10Q filings.

Zynga reported just $231 million in revenue last quarter, down more than $100 million year over year. Zynga called for another sequential drop in revenue of $31 million to $56 million for the third quarter. It also expects to post a net loss of between $14 million and $28 million.

What a mess.

Can Zynga right the ship under new CEO Don Mattrick? He seems to think so. In the latest earnings release, he predicted that the next few years will be "a time of phenomenal growth in our space," and said, "Zynga has incredible assets to take advantage of the market opportunity." Sounds great! But he also later stated, "We have a lot of hard work in front of us and as we reset, we expect to see more volatility in our business than we would like over the next two to four quarters." 

A changing business plan
Mattrick plans to "reset" the business model. He said Zynga's biggest opportunity is in free-to-play social games. This is a reversal, since Zynga at least originally built itself on a pay-to-play model. Zynga is now virtually starting from scratch. This shift is concerning.

Consider these two things: First, less than 12% of Zynga's revenue last quarter was from advertising. Even the paltry $27 million and change was down sequentially from $34 million. Second, the shift to mobile tends to work better as a pay-to-play model rather than a free, advertising-based model, as seen with apps on the iPhone and iPad. Let's face it: People don't pay much attention to ads while playing a game.

Zynga's unclear mobile monetizing strategy
In Zynga's latest conference call, the word "mobile" was uttered 36 times. COO David Ko noted that Apple's payments to developers over the last 12 months were up roughly 120% from the prior comparable period, and Google reported in May that Google Play purchases were up 700% year over year.

"It's clear that the market around us is growing at a tremendous (rate), and it is equally clear that we're not capturing our fair share," Ko said. "In short, these results are unacceptable and as Don stated, we can do better." Zynga gave no details on its strategy to monetize an advertising-based model. Even the examples it gives with Apple and Google are based on pay-to-play models.

Compare Groupon (NASDAQ: GRPN  ) to Zynga. Groupon had its IPO in November 2011, the month before Zynga. Groupon is a company that has been successful with mobile monetization. Many people had thought Groupon was on its death bed (as seen in its stock price a few quarters ago). Now Groupon is forecast to have record sales and net income in the holiday fourth quarter..

Groupon last reported a record quarter in North America, owing a large part of that success to the shift to mobile. Its CEO said the company  continues to "gain traction in mobile," with nearly 50% of North American transactions coming from mobile in June. More than 50 million people have downloaded Groupon apps globally, he said. Investors should look for evidence of similar traction for Zynga in its earnings releases and conference calls. Zynga could surprise Wall Street and be successful with whatever plan it has -- and failed to communicate -- like Groupon did.

Final takeaway
It may be premature to count Zynga as dead quite yet, but at a $3 billion market valuation there is already a high degree of success priced in.  Groupon trades at around three times sales. To justify that kind of valuation, Zynga would need $1 billion to $1.5 billion in sales, which it is nowhere near. Pay particular attention to the advertising portion of its revenue rather than just its overall revenue. This will tell you more information about how successful the turnaround plan is progressing. For now, Zynga is a quite speculative investment, and speculation shouldn't come with such a large price tag.

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