Is Zynga Finished?

Zynga (NASDAQ: ZNGA) is a leading provider of social games, with 123 million monthly unique users spanning the globe. The company primarily collects money through the sale of virtual goods in its games, and is best known for the popular Farmville franchise. Zynga is unfortunately goring through a difficult period, with ongoing concerns ranging from casual-user fatigue to competition and marketing constraints following a major shift in management, as well as the recent decision to lay off over 500 employees.

Next generation risk

The upcoming launch of  Microsoft's (NASDAQ: MSFT) Xbox One may place pressure on Zynga's key metrics - especially if it steals any portion of the 2.5 million users that drive virtually all of the company's revenue. I believe that hardcore gamers play a mix of games, and their use of social-game platforms does not preclude them from playing traditional console games. If this were not the case, we would not see record-breaking sales of traditional games like Call of Duty: Modern Warfare (which raked in $1 billion in sales over 16 days). 


According to analysts at Janney Capital, there is a substantial risk that 60% to 80% of Zynga's 2.5 million users are  likely to shift their time and spending to next-generation systems at the expense of casual games.

In Zynga's defense, according to former CEO Mark Pincus, the company sees its peak hours during work hours, where consoles are not able to compete. Unfortunately for Zynga, Microsoft is also developing games for its Windows-based smartphones, and will also offer many of its popular games to iPhone and Android phones later this year. Windows 8 users can currently play games such as Halo: Spartan Assault using their usual Xbox Live gamer profile.

Gamers are migrating elsewhere

A lot of the growth expectations around social games are what I believe to be overly optimistic, which over a long enough term will dictate a shift to other gaming platforms. With Zynga failing to impress users with any new popular games, the company has seen declines in its user base. Monthly unique users (MUU) have declined for the past year, and engagement is down 22% over the past two years. Monthly unique payers have also declined from 2.5% of MUU in 1Q 2011 to only 1.5% today.

The success of Zynga's games makes it easier for the company to advertise its other games. However, this may increasingly be a vicious cycle, as a drop in MUU and lack of popular games makes it more difficult (and expensive) to market its titles and attract new customers.

Xbox isn't the only form of competition

There are relatively low barriers to entry in the casual-games business. Developers can create games for a fraction of the cost of traditional console and PC games, and can get mass distribution via online platforms and downloads on Apple's iTunes and Google's Playbook.

We are also seeing a number of well-capitalized companies enter the space, such as Kongegate, owned by the largest game retailer GameStop, and Disney's Disney Games. Zynga is also threatened by traditional developers like King, which recently surpassed Zynga's once-coveted status as the largest platform on Facebook with roughly 160 MUU. As of March, King's (highly addictive) Candy Crush Saga surpassed FarmVille 2 as the most popular game on Facebook, with 46 million average monthly users.

What company is worthy of an investment?

Electronic Arts (NASDAQ: EA) is one of the largest independent publishers and distributors of interactive games for all platforms, including game consoles, PC's and handheld devices such as mobile phones and tablets. What impresses me most about this company is that it understands mobile and is able to monetize accordingly.

Electronic Arts' mobile and handheld revenue was up 30% year-over-year to $103 million, with 73% growth driven by smartphones and tablets. Results were driven by Real Racing 3 (the top racing title on Apple) and The Simpsons (top five grossing game on Apple). The company is better known for its Madden NFL, Need for Speed, Battlefield, StarWars MMO, and the The Sims franchises.

On a shorter-term basis, investors can be optimistic regarding Battlefield 4's pre-order data (on consoles and PC). Based on critical reviews on YouTube and gaming forums, the new release should perform at least in-line with Battlefield 3 (and could outperform similar shooting games launching near the holiday season).

Longer term, the company is banking on the potential success of recently announced Star Wars games, as Disney is aiming to make its interactive unit profitable. Electronic Arts has received the right to develop new Star Wars games for consoles, computers, and mobile devices. While financial terms and other details were not released, the partnership could provide tremendous upside for Electronic Arts.

Disney is planning to release a new Star Wars film every year starting in 2015, with video games likely to follow. According to various blogs, the first game will "most likely" debut around the same time as the movie (a very brief teaser can be seen on Youtube here) in what Electronic Arts' executives have dubbed as a "rebirth of the brand."

Conclusion

Zynga's $1.5 billion sitting idle on the balance sheet could be used to invest in new ventures or be committed to a larger buyback (only $200 million is currently authorized). The cash gives Zynga a good amount of breathing room and could be a large source of upside if used in the right way.

Hiring former Xbox boss Don Mattrick gives the company inside knowledge on how to fend off competition from Microsoft. On the other hand, the high level of senior management turnover can undermine vendor confidence, while making it more difficult for investors to assess the company's strategic goals.

All that being said, I believe Zynga offers nothing attractive to shareholders as the stock is unlikely to recover from its March 2012 highs. Electronic Arts, on the other hand, has seen a consistent rise in share prices since July as investors are regaining confidence in the company's ability to release popular games over the years to come.

From what I have read, Microsoft is set to dominate the console wars, and with an impressive game lineup announced, I can't see how Zynga can compete against these two companies.

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The article Is Zynga Finished? originally appeared on Fool.com.

Jayson Derrick has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft. 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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