In 2016, mobile gaming worldwide made as much revenue as the global box office, yet there aren't many individual companies that are clearly leading in the market.

In this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu take a close look at two of the biggest companies in the mobile gaming space, Zynga (NASDAQ:ZNGA) and Glu Mobile (NASDAQ:GLUU). Find out how both companies operate, how they're doing in the short and long term, what the biggest risks facing mobile game developers are and how they're facing them, some of the less risky ways for investors to get exposure to the mobile gaming market, and more.

A full transcript follows the video.

This video was recorded on June 2, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 2, and we're following up on our gaming episode with a look at mobile gaming companies. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com senior tech specialist Evan Niu. Evan, how's it going?

Evan Niu: Pretty good, happy Friday!

Lewis: Happy Friday. We had a little bit of a false start today. I made my way down to the studio only for the building's fire alarms to go off and send us outside. So, a little setback. We're recording the show a little bit later than we normally do. But I guess you got a little extra time to play with your kid, right?

Niu: [laughs] Yeah. I had no fire alarms in my house.

Lewis: Although, you do have them installed, right?

Niu: [laughs] Yeah.

Lewis: As I mentioned in our intro, we talked about gaming last week. We actually had a listener, Frank, reach out to us on Twitter and basically asked, "I listened to the video game episode you guys did. You mentioned EA, Activision, and Take-Two as the big three. What other companies are in the gaming space, and how should we think about them?" So, looking at the video game landscape, those are really the big ones when it comes to console publishers. If you're looking for other ways to invest in gaming, you have the console makers, you have the companies like Sony and Microsoft, and then you have some of the companies that make components that go into consoles or computers like NVIDIA. Then, you also have mobile game publishers like Zynga and Glu Mobile. The difference here is they are creating games, publishing games, however, they are doing it almost exclusively for mobile devices. We're going to take a look at the mobile game publishers today. But I think before we get into that discussion, Evan, a couple stats that paint a picture on what's going on with mobile gaming.

According to numbers from SuperData research, mobile gaming hit worldwide revenue of over $40 billion in 2016, which was up 18% year over year, and actually equal to global box office sales for the year. And most of that spending is coming from Asia. About 60% came from that region. The North American market was worth roughly $7 billion. That's all to say that there's a lot of tailwinds for this industry, and it's certainly growing. There's a lot going on, and I can see why investors would be interested in it.

Niu: I'm not a huge fan of mobile gaming companies. If you look at the Zynga and Glu Mobile, those are the more well-known names in the space, and how they've done over the years, it's been very poor. Both companies are trying to put together these turnarounds. They both have new CEOs and they're both making pretty substantial pivots in the strategy. I used to criticize Zynga all the time. They used to copy people shamelessly, the CEO, Mark Pincus, he's still very involved in the company, but he was such a terrible leader, and then they had Don Mattrick come in for a year, and then they got rid of him. There's been so much turmoil with Zynga. Last March, they hired Frank Gibeau from EA, who had 20 years of experience at EA. He's a very well-respected industry veteran. He's been really leading the shifting strategy away from these one-hit wonders, and more toward trying to make the business more sustainable. These companies put so much money into trying to develop these games, and a lot of times they just flop, because mobile game platforms are so competitive, and it's really hard to set yourself apart. So, what they're doing now is, while they're slimming down how many games they make, they're still trying to invest in the games that are bringing in money. Zynga and Glu call these different things. Zynga calls them "forever franchises," where Glu calls them "evergreen titles." But, yeah, they mean the same thing, it's these games that have been out there for a while that were big hits, still bringing in revenue streams. For Zynga, that's stuff like Zynga Poker. For Glu, it's like that Kim Kardashian game, for example. There's a lot going on with these companies. But it's just a tough space. 

Lewis: Yeah. I think the narrative is very similar for both of these. Both of them had their top lines peak some time a couple years ago, and they're kind of trying to figure out how to get back to those good days. For Zynga, the company's top line peaked in 2012 at $1.3 billion. That was really fueled by their Farmville franchise, which is maybe what they're best known for. They also have Words With Friends and some casino-type games as well. They had a partnership with Facebook (NASDAQ: FB) for a long time, and that was really just throwing gas on the fire and fueling growth for them. They have since fallen back to around a $750-million-per-year top line. Looking at that number over the past 12 months, the company lost $100 million. They are not profitable on a GAAP basis. Eighty-three percent of their top line comes from mobile games, so they are what we would consider a pure play here for those purposes. And the story here with Glu is very similar. The company's annual revenue peaked in 2015 at around $250 million, and has largely since lagged. They are also losing money. They lost $100 million on $200 million in revenue over the last 12 months. They pull in about 86% of their revenue via in-app purchases. The rest comes via ads. But, they are, by and large a pure-play when it comes to mobile games. 

You mentioned how they are looking to make that shift over to evergreen. That's really where we see the console publishers have a lot of success. So it's understandable that they want to make that pivot. I'm just not really sold that that's really something they're going to be able to do given the nature of the mobile gaming industry.

Niu: Yeah. It's tough. If you remember, Zynga, a few years ago, had that acquisition of OMGPop which was a one-hit wonder, they made Draw Something and they immediately wrote down -- it was literally immediately, like six months later -- the entire acquisition. That was many years ago, but it's just an example of how tough the space is. There's so many one-hit wonders in mobile games. You can't just keep chasing those. For Glu, they used to have this big strategy of celebrity-based games. The Kim Kardashian one was the big one, but they had games with Katy Perry, Nicki Minaj, they have a cooking game now with Gordon Ramsay, they have another game coming out with Taylor Swift which was delayed from last year to this year and they're betting big on that. But overall, they're trying to move away from that whole celebrity-based strategy because, obviously, celebrity endorsements are very expensive and they're very risky, because if they flop then you just spent a ton of money to get this celebrity on board to partner with. And if the game flops, it flops, and everyone loses. 

If you look at Zynga, I think investors are giving them credit for the turnaround. The stock is up almost two-thirds since Gibeau became CEO. Mobile revenue and bookings are both at record levels. So I think they are making progress on that turnaround. But if we look at the bigger picture, for example, five years ago, their total monthly unique user base was about 180 million. Today, it's less than 60 million. That's less than a third. Their user base is definitely shrinking, without a doubt. They are making some progress in terms of getting paid, converting non-paying players to paid players. But that's a growing slice of a shrinking pie, so it's tough to see where this goes long-term. To their credit, their user base seems to have stabilized in the 50 [million]-60 million range. It's not like it's falling rapidly from here. It's starting to flatten out. So, they do have a business they could build with that player base. That's still quite a number of people. And then, if we turn around and look at Glu Mobile, in terms of more similarities, they just acquired CrowdStar in December for $45 million. The big game there is Design Home, which is an interior design game that targets female players, predominantly. That's starting to see a lot of success. That was the big driver in bookings last quarter. But, these companies have to rely on one-hit wonders and acquisitions, and I just don't see a lot of appeal as an investor. Obviously, from an investing standpoint, you've all seen a company that has a long-term sustainable competitive advantage that can actually consistently turn out good games. But mobile games is just a cutthroat industry.

Lewis: Yeah. We see the difference between the mobile game publishers and the traditional publishers there. When EA comes out with the next version of FIFA, or EA comes out with the next version of Madden, you have people ponying up because they want the updated version of that. And generally, the life cycle of a customer on those traditional games tends to be a lot longer, they tend to play the game a lot longer, the retention is a lot better. I think one of the other issues that these mobile publishers run into is, they operate on the freemium model. For people who aren't as familiar with that, the idea is, these games are free and they bank on advertising and in-app purchases or microtransactions to really fuel the revenue growth and monetize the platform. I was actually talking with Austin Morgan before the show, and we were talking about Candy Crush, which is owned by King Digital, and he said his mom has been playing Candy Crush forever and she has never paid to actually use it, she's never using any of the in-app purchases that are available, she's only playing it to the extent that it's free for her. That might make for a good user experience in allowing people to play for a long time, but it does not necessarily make for a great business.

Niu: Yeah. In-app purchases are so predominant in this industry now. I don't know. There's been a lot of debate over this for years, about how sustainable this is in contrast to the legacy models, charging a price up front for a game that you keep and maybe get some paid content on top of that as an add-on. But most in-app purchases are just digital consumable resources within the game. You buy it and you immediately use it, and you're just left with a feeling that you just wasted some money because you used whatever you bought and it's gone and now the game is prodding you to keep spending and spending. It's crazy, maybe because I used to play a lot of poker, but, Zynga Poker is still huge and it's one of the big drivers. But I don't understand why people would pay money for fake chips that you can never cash out. Maybe it's just because I played poker, but that just sounds crazy to me. But a lot of people do it. That's one of their "forever" franchises, it's been around for almost 10 years, and it's still quite popular, there's still tons of people on there and it just boggles my mind.

Lewis: Yeah, I think a lot of these companies fall into the 80-20 rule in a lot of ways. You have 80% of your revenue coming from about 20% of your customers.

Niu: In Zynga's case, it's more like 2%. Their pay conversion is like 2.3% last quarter.

Lewis: Right, which gives you a sense of what a small chunk of people are really floating this company along. You see numbers like daily actives, and obviously that's been trending down for some of these companies lately. But it's an even smaller fraction of that which is really at the core of what's driving business results for them. That's not a large base to work off of.

Niu: Right. Freemium is the way to go, because all the top-grossing games in the app stores are freemium games. So, clearly this is the model that works for some people. But I think that the big lesson that they both have to learn is, you can't really invest tons of money in development on these new games that have really short shelf lives. It doesn't really make a whole lot of sense to invest a ton of money on a risky bet like that. Yeah, there are these success stories. But it's a numbers game, and the numbers are not in your favor.

Lewis: So, Evan, getting back to our conversation, I teased that I would talk a little bit about some of the app store rankings that we see from some third-party research firms. App Annie is kind of the authority in this space. You can go to their website, they make their most recent month's data available. I think one thing that highlights the trouble for Glu Mobile and Zynga is that they don't really appear too prominently in the rankings of top-grossing apps. Neither of them have a game in the top 10 on that list, at least specific to iOS right now. They were two of the big fish in the space just a couple years ago, and I think that really speaks to how much turnover there is in user interest when it comes to mobile gaming, and how hard it is to sustain success.

Niu: Yeah. I think part of the issue is that, if you compare mobile game platforms compared to something like console game platforms, there's so much more competition on the mobile side, because the barriers to entry are so low. On one hand, it's inspiring, because you can have these small, indie game developers that can really compete on equal footing with these gaming giants. There are plenty of stories of people who hit it big, small independent developers that are just a handful of people, and they can really hit it big and see considerable success, versus a console game where the R&D costs on a console game are incredibly high, you have licensing fees you have to pay the console makers, you have distribution. The barriers to entry there are much higher. It's really hard for a small, independent developer to really make a compelling game, particularly on these AAA games. We're talking about EA and Activision, they do really good with these blockbuster franchises that they refresh every year. That's not something that an indie game developer can really compete on. But on mobile they can. So there's a floodgate of competition. There's so many games on mobile that it's really hard to stand out. Consumer preferences change, everyone is fickle because no one pays for games, so you don't really have an incentive to stay. If you got a game free and you don't like it, you just delete it and move on, versus in console games, you paid quite a bit of money, so you're going to play the game. I think the competitive landscape is very different fundamentally. That's why, there is a lot of opportunity in mobile gaming, because there's a lot of money. But I think the better play is to pick the big guys, the game makers, that are expanding into mobile, while they have their core businesses that are solid and profitable, that can have these more sustainable cash flows, versus the route of going for one of these mobile-only pure plays like Zynga or Glu Mobile. There's just no sustainable advantage, in my mind.

Lewis: Yeah, I have to agree with you. I think that when you look at an Activision or an EA or a Take-Two, porting over what has been a very successful franchise to mobile, which is absolutely what a lot of those companies are trying to do, that looks a lot more appealing, it looks a lot more successful. Even if it doesn't work out, you can fall back on the base of these really strong console businesses that they have. You're banking on catching lightning in a bottle repeatedly with looking at the pure-play mobile game publishers. At least my investor takeaway for this conversation, and the broad gaming space, is that it's better to be with a slightly more diversified and more established traditional publisher, because it's so hard to predict success, even as you're seeing these turnarounds with Glu and Zynga, just because of the nature of the industry they operate in.

Niu: Right. They're up for the past year, but where are they going to be in three to five years? You really can't even answer that question, because things change so quickly. But, yeah, there's a lot of opportunity, so it's important for the big guys to expand into. Activision bought King Digital. We talked about Candy Crush earlier. That's one of their methods to get some mobile exposure. EA has made some pretty good acquisitions on mobile. They got Plants Vs. Zombies a few years back. So, yeah, I think it's important for some of these companies to capitalize on that opportunity. But at the same time, those pure plays are just too risky in my opinion. I would never touch any of them.

Lewis: Frank, I hope that answers your question. Listeners, if you have any questions you want us to hit on the show, you can always tweet us @MFIndustryFocus, or shoot us an email at industryfocus@fool.com, and we'll be sure to hit it. We love getting questions from listeners. It takes all the brainstorming for show ideas out of our hands. Evan, anything else before I let you go?

Niu: No. I think we hit it pretty well. Stay away from these companies. [laughs] 

Lewis: [laughs] Sage advice. Well, enjoy your weekend, man! I'll talk to you next week.

Niu: You, too!

Lewis: Listeners, if you're looking for more of our stuff, you can subscribe on iTunes or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you to Austin Morgan for all of his work behind the glass. This was a particularly problematic episode for me, got a rough night's sleep and it clearly came across in the recording. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Dylan Lewis owns shares of Facebook. Evan Niu, CFA owns shares of Facebook. Evan Niu, CFA has the following options: long January 2018 $120 calls on Facebook. The Motley Fool owns shares of and recommends Activision Blizzard, Facebook, Nvidia, Take-Two Interactive, and Twitter. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.