Things are looking up for Zynga (NASDAQ:ZNGA). After struggling for years to find its footing in the mobile games market, sales on smartphones and tablets are now growing fast enough to outpace declines for its browser-based titles, and the company has been employing a more cost-conscious development approach that's producing encouraging top- and bottom-line results. Mobile sales increased 30% year over year and accounted for 86% of sales last quarter, overall revenue climbed 15% to a three-year high, and improving operating margins suggest the company will finally be able to deliver profits on a regular basis.
Zynga's upswing appears to be poised to continue in the short term, but the company will still need to execute at a high level and improve in key areas in order to build sustainable success in the competitive mobile games market. Read on for a look at three threats that could sink the company's turnaround effort.
1. Zynga's core franchises could falter
Zynga's comeback hinges on what it calls "bold beats" -- periodic content updates that are designed to keep players engaged in its major franchises. When the company is able to increase engagement and spending through downloadable expansions and in-game events, it can typically generate a much higher return on investment than if it spent the same amount on developing new games.
This strategy is allowing Zynga to operate a lean business and could help it transition to consistent profitability in the near term, but the momentum that the company currently enjoys will likely evaporate if a few key titles begin to underperform. The pie chart below shows the revenue contributions of Zynga's games in its last reported quarter -- with franchises that account for less than 10% of sales grouped together in the "other" category:
While the company's slot-machine games are currently the biggest revenue contributor, it's Zynga Poker that has been the biggest source of sales and earnings momentum over the last year, with mobile revenue for the game in the quarter ending in June up 61% year over year and daily active users (DAUs) up 71%. For comparison, revenue from the Slots franchise, which encompasses a wide range of slot-machine titles, increased 6% year over year.
The need for franchises including Zynga Poker, Slots, and CSR Racing to continue delivering solid growth is compounded by the fact that some of its other big properties are losing their pull. The Farmville franchise, which still has a substantial portion of its audience on browser platforms, is in decline, and Words With Friends also looks to be on a downward trajectory.
The chart above only tracks contributions from titles built around in-game purchases and does not include revenue from ad-based games, a segment that seems to be weakening. Words With Friends is Zynga's biggest ad-based game and saw sales drop 15% year over year last quarter. Overall advertising revenue fell 1% year over year to make up 22% of sales, even with the launch of Crosswords With Friends and the positive impact from solitaire games that the company added with its $46 million acquisition of Harpan.
Right now, it looks like the company's big growth drivers will be Zynga Poker, Slots, and CSR Racing. If growth for these properties slows substantially or sales start to decline, Zynga's growth outlook and stock performance will be negatively impacted.
2. Failing to deliver new hits
Even if Zynga's core properties continue to have staying power, the company will likely need to deliver new hit properties in order to keep its growth engine going and justify trading at roughly 40 times forward earnings estimates. Zynga Poker has been delivering stellar results in recent quarters and will remain the key growth driver in the near term, but it's the type of game that's particularly susceptible to competition, and the company will need to shift resources to establishing new properties at some point. Zynga has done a commendable job of growing engagement for some of its core franchises over the last year, but releasing fresh and innovative titles has never been one of the company's strong suits, and eventually it will need take on more of the risk that comes with establishing new intellectual properties.
Focusing on what's working and getting the company into consistently profitable territory is a good move in the short term, but relying too heavily on bold beats for its existing catalog could be a recipe for disaster.
3. Making bad acquisitions
Zynga has $739 million in cash and short-term assets on the books against zero debt, so the company has room to grow by purchasing and absorbing smaller game studios. With bold beats for its core properties taking top priority, and the company's internal development of new games looking like it will mostly be focused on small-scale titles, that leaves acquisitions as the one of the company's most likely avenues to adding big new franchises to its catalog.
Zynga has a long history of purchasing smaller studios, having made over two dozen acquisitions since 2008, but many of its biggest M&A moves have had mixed to poor results. For example, the company purchased developer OMGPop in 2012 for $200 million but shuttered the studio a year later. Additionally, the company's $527 million acquisition of Natural Motion brought CSR Racing into the fold, but the studio's other major releases have underperformed and call the price paid into question.
For investors, there's a danger that Zynga will continue to shell out big money to acquire studios that have a couple promising properties that quickly lose their marketability -- depleting the company's cash pile and driving up its operating expenses without delivering sufficient contributions to the overall business.