Zynga's Big Acquisition Doesn't Make Much Sense

Zynga is paying $527 million for Natural Motion, even after the recent failed acquisition of OMGPOP. While Natural Motion owns middleware used in games like Grand Theft Auto from Take-Two Interactive, Zynga is paying a steep price for this technology. With increasing competition in the mobile game market, Zynga may have a tough time turning a consistent profit going forward.

Feb 4, 2014 at 7:00PM

Shares of game company Zynga (NASDAQ:ZNGA) soared recently on an early earnings release, coupled with news of a half-billion-dollar acquisition and planned job cuts. Zynga is buying U.K.-based Natural Motion, responsible for mobile games like Clumsy Ninja, as well as middleware used in triple-A console games from companies like Take-Two Interactive (NASDAQ:TTWO). Zynga's previous high-profile acquisition of OMGPOP ended in disaster, with the company shutting down the studio and laying off much of the staff. With big game companies like Electronic Arts (NASDAQ:EA) increasingly pushing into mobile, will this acquisition help turn Zynga around, or will history repeat itself?

A look at Zynga's results
Zynga's revenue plummeted in 2013, down more than 30% compared to 2012, but the company managed to cut its losses. A $209 million net loss in 2012 was trimmed to just a $36 million net loss in 2013, largely due to cost cuts resulting from previous layoffs and studio closings. An additional round of layoffs, announced along side the acquisition, will cut costs even further.

Daily active users in the fourth quarter totaled 27 million, down from 56 million in the same quarter last year. This massive drop is troubling, given that Zynga needs a huge user base to drive in-game transactions. Since only a small percentage of players buy in-game items, this halving of the user base is not a good sign.

A pricey acquisition
Zynga expects the Natural Motion deal to add between $70 million-$80 million in bookings and $15 million-$25 million of EBITDA in 2014, putting the $527 million acquisition price at more than 20 times the high-end EBTIDA estimate. That's a high price to pay, no matter how you look at it.

Zynga benefits in two ways from this deal. First, Natural Motion has two hit mobile games, Clumsy Ninja and CSR Racing. This expands Zynga into new genres, and should help boost daily active users, provided the games remain popular.

The problem with mobile games is that they often don't stay popular for long. OMGPOP's hit game was Draw Something, but by the time Zynga acquired the company, the game was already past its prime. In the free mobile game market, the flavor of the week changes frequently, so new games acquired by Zynga don't justify the price tag.

The second benefit for Zynga is Natural Motion's middleware products. The most notable is Euphoria, a system that simulates a character's muscles and nervous system to produce realistic motion on the fly, without the need for canned animation or motion capture. It's impressive technology, and it's used extensively by Rockstar Games, a subsidiary of Take-Two. Both Grand Theft Auto IV and Grand Theft Auto V use Euphoria, putting the technology in two of the best-selling games in recent history.

While this may create a stream of revenue for Zynga, it doesn't fit with the company's business model. Zynga's popular games, like Words with Friends and Farmville, aren't technological marvels. Perhaps the company is pushing to increase the quality of its games with this technology, but it chose an expensive way to do so. Zynga could have simply licensed the technology, with the middleware used as justification.

The deal is being paid for with $391 million in cash plus 39.8 million shares of Zynga, so it will both partially deplete Zynga's cash balance and dilute the holdings of existing shareholders. The market's reaction to this deal doesn't make much sense -- Zynga seems to be following the same costly acquisition strategy of the past. Buying currently popular mobile games for hundreds of millions of dollars is a losing strategy, and Zynga doesn't seem to get the hint.

The mobile game wars
Zynga has more serious competition in the mobile game market than it did a few years ago, with traditional game studios getting serious about mobile. Electronic Arts has been leveraging its PC and console franchises to bring free-to-play games to mobile platforms, with titles like Madden, FIFA, and The Sims now available on mobile devices. EA generated $125 million in sales from mobile games in its most recent quarter, up 26% year-over-year. Although there's plenty of competition, EA's portfolio of popular franchises should give it a bit of an edge.

Going forward, it will get more difficult for free-to-play mobile game companies to turn a profit, as there is essentially no barrier to entry. A single person can create a game that goes viral, knocking games built by multi-national companies off the app stores' top spot. The recent viral hit Flappy Bird is a good example, a simple, frustrating game built by one man in just a few days. As of this writing, Flappy Bird is the top free game on the Google Play Store, knocking Candy Crush Saga, a game from industry behemoth King.com, into the number two spot. That's how fickle the free-to-play mobile market is, and that's why Zynga is going to have a tough time consistently turning a profit.

The bottom line
Zynga can buy up all of the popular mobile games, but at the end of the day, the company is competing in an industry with no barrier to entry. Zynga paid a steep price for two games and some middleware, and I expect that the fate of Natural Motion will be similar to that of OMGPOP. Zynga is still a mess of a company, and this acquisition doesn't help.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Take-Two Interactive. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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