Here's Why Investors Should Avoid Zynga, Inc.

Zynga may be moving in the right direction, but I'm unwilling to buy the stock for two key reasons.

Apr 25, 2014 at 10:05AM

Zynga (NASDAQ:ZNGA) released first-quarter 2014 results earlier this week, and I'll admit they weren't terrible.

In fact, despite the market's decidedly "meh" response, with shares closing down around 1.6%, investors are rightly encouraged that Zynga managed to return to sequential growth in bookings, adjusted EBITDA, mobile bookings mix, and audience for the first time in two years.

But that still doesn't mean I'll be buying the stock anytime soon, and I think fellow investors should avoid the stock as well.

Zynga, King Digital battle for supremacy in the free-to-play space

Source: Zynga.

First, the numbers
Before we get to that, let's recap Zynga's most recent quarter. 
Revenue fell 36.3% year over year to $168 million, which translated to a net loss of $61.2 million, or $0.07 per share. On an adjusted basis, however -- which excludes things like acquisition expenses and stock-based compensation -- Zynga reported a net loss of just under $6.3 million, or roughly $0.01 per share. By comparison, analysts were looking for the same $0.01-per-share loss but on lower sales of $146.52 million.

Meanwhile, bookings -- which are Zynga's key measure for in-game virtual goods purchases -- came in at a respectable $161 million, and adjusted EBITDA were $14 million. Both figures are well above Zynga's previous guidance, which called for bookings in the range of $138 million to $148 million and adjusted EBITDA of $5 million to $10 million.

What's more, Zynga announced its much-maligned founder and former CEO Mark Pincus has decided to move on from his operational role as chief product officer. Instead, he'll focus on continuing to serve as chairman of Zynga's board of directors.

So why am I not biting?

Bad economics
First, I need to see more than a single quarter of sequential improvement to know Zynga's business is sustainable over the long term.

Zynga still overwhelmingly relies on the success of a few key titles like FarmVille and Words With Friends, and even with its shift toward more visually beautiful titles with the help of NaturalMotion -- which could negate the perceived importance of its remaining preacquisition employees (more on that below) -- it still needs to overcome the increasingly difficult challenge of continuously pumping out and monetizing free-to-play games.

That's not to mention ever-increasing competition in the space for consumers' already-limited attention, including the recently IPO'd King Digital Entertainment (NYSE:KING). Of course, King Digital also suffers from a terribly risky overreliance on its hugely addictive Candy Crush Saga, which it most recently announced will expand to Tencent's fast-growing WeChat messaging platform. We should know more about King's plans to diversify when it reports earnings two weeks from now, but it's clear Zynga is far from alone anymore.

Oh, the irony
But that's also why Zynga acquired NaturalMotion for $527 million last quarter, right? NaturalMotion's 260-person team already had a few hugely successful titles to its name, including Clumsy Ninja and CSR Racing. Its game-development tools and simulation tech are also world-class, so you can bet Zynga has something coming down the pipe to differentiate itself as competitors like King Digital arise.

However, even as the market applauded the move, I'm still having a hard time looking past the terrible irony in Zynga's purchase. Namely, I was appalled when it simultaneously announced a "cost reduction plan" primarily involving the elimination of 314 employees -- or approximately 15% of its workforce.

Zynga boasted the move would save around $33 million to $35 million before taxes in 2014, but that excludes the $13 million in related restructuring charges it had to take this quarter. This also completely ignores the risk associated with harder-to-quantify survivor guilt, which could be a massive drag on the productivity of Zynga's remaining core employees.

Don't get me wrong: Perhaps the layoffs were necessary given Zynga's faltering core business. But they were ill-timed, at best, and it's hard to remain confident that Zynga is doing the right thing given its checkered past of shareholder un-friendly actions and exodus of high-profile engineering talent.

Then again, if Zynga is moving in the right direction, it could reward investors handsomely for their willingness to take a calculated risk on its eventual sustained profitability.

For the reasons above, however, I still can't bring myself to buy its shares.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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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