Social-gaming company Zynga
It seems that Zynga is the Samsung of gaming. Last week, Electronic Arts
In fact, fellow Fool Evan Niu gave investors an inside look at Zynga's history of faux innovation in an illustrated column that I encourage you read. Worse still, EA isn't the only one waging legal war against the game developer. Last month, Reuters reported that a California law firm filed a class action suit against Zynga for failing to divulge crucial data.
While these cases could take years to sort out, a more immediate problem for Zynga shareholders is the looming lockup expiration. Next Thursday, Zynga's fourth lockup period will be lifted since the company's IPO last December. The expiration could flood the market with sell orders if many of the 150 million employee stock options in question are exercised.
A dysfunctional marriage
Zynga's demons threaten not only its own business but also Facebook's as well. That's because the social network depends on Zynga for about 15% of its revenue. Therefore, when the game publisher missed its second-quarter earnings last month, the social network also felt the heat.
Zynga posted a quarterly net loss of $22.8 million for the three months ended June 30. For reference, this compares with a net gain of $1.4 million for the same period a year ago. The company also saw a dramatic dropoff in players from Facebook (16%, to be exact) for the quarter compared with the prior year.
As if the second-quarter earnings deficit wasn't bad enough, Zynga also reduced its guidance for fiscal 2012, causing shares to slide as much as 42% on the lowered outlook.
Yet even more disturbing is that Zynga CEO Mark Pincus blamed the company's earnings shortfall on Facebook. Specifically, management accused Facebook of diverting users away from existing Zynga options and toward new rival games. But instead of making excuses for its poor performance or stealing ideas from other game publishers, Zynga should focus on developing a mobile strategy to help lessen its reliance on Facebook.
Raising another red flag for the future of the company was the sudden resignation of Zynga's operating chief, John Schappert. News of Schappert's departure from the company and its board of directors broke yesterday. The management shakeup comes at a bad time for Zynga, which is also struggling with added rivalry in an already uncertain market.
Amazon takes the spotlight
As Zynga focuses on building a gaming platform outside Facebook, it also faces new competition in the space. Amazon.com
This free-to-play is the first from Amazon Game Studios, but it won't be the last. Unlike Zynga, Amazon is showing initiative, and perhaps more importantly, it isn't stealing game designs from rival developers. Given Amazon's history of disruption in other industries, I don't think the online retailer will have a problem challenging Zynga in the gaming space, particularly because of the fragile state that Zynga finds itself in these days.
In addition, the freemium business model that Zynga champions is largely unproven. Whether Amazon will have better luck than Zynga in monetizing its games remains to be seen. But for the time being, both of these companies must make sense of an industry that's still in its infancy.
The hard truth
Slowing revenue growth, legal complications, and a serious lack of creativity have drained the appeal from Zynga. Today, I'm embarrassed to admit that Zynga stands as my all-time worst stock pick. You could argue that at $3 a share, the stock represents a rebound opportunity for patient investors. However, from an investment standpoint, I'm afraid the risk now outweighs the potential reward.
At this point, there's little doubt that Zynga will underperform the market in 2012. At worst, Zynga is a short-lived fad that will slowly fade into irrelevance. At best, it is a design copycat that will ride other game developers' creations to higher profits. For an in-depth look at how to play the gaming stock today, check out this new premium analysis report on Zynga. In addition to market research, you'll also get timely updates and notifications on the stock -- get started now.