Zynga Slumps On Steep Profit Decline As All Eyes Are On New CEO

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Zynga’s (NASDAQ:ZNGA) stock fell almost 15% as the company released its disappointing second quarter results Thursday. The decline was higher than we expected as the social gaming giant’s web bookings fell by 44% as compared to the same period a year ago. [1] The figure came down significantly compared to the first quarter as well due to the closure of certain under performing games and surprising weakness in Texas Holdem Poker, which is been one of the key game franchises for the company. In addition, Zynga did not disclose much about the traction it is getting in the U.K. for its real money games, and has decided to not pursue the license for the same in the U.S. In other words, there was virtually no progress except for the slight sequentially improvement in mobile bookings and better performance from Farmville franchise. Zynga’s future looks uncertain right now, and its new CEO has a gigantic task of turning around the company and build a more loyal customer base.

However, the company was able to reduce its expenses slightly as it laid off 628 employees under its previously announced workforce reduction program. In early June, Zynga stated that it would cut around 18% of its workforce for an estimated $70-$80 million in pre-tax savings for the company. The company is going through a rough patch, and its financial performance is likely to fluctuate as it reorganizes its core business and invests in new growth avenues.

Check out our complete analysis of Zynga

Texas HoldEm Poker & Farmville Are The Only Major Games Left

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Texas HoldEm Poker, Farmville and Farmville 2 constitute roughly 20%, 16% and 15% of Zynga’s online gaming revenues respectively, with no other game accounting for more than 10%. [1] Farmville 2 did well in the first quarter and user statistics from appdata.com suggest that the game is going strong. For now, it averages close to 26 million MAU, which is higher than our estimate for 2012. Zynga stated that Farmville and Farmville 2 grew their combined bookings by 29% in Q2 2013 compared to the same period a year ago. [1]

Given the above metrics, the weakness in Zynga’s Poker franchise isn’t a good sign and played a major role in the company’s revenue decline in the second quarter. The situation was further worsened by the closure of The Ville, Empires & Allies, Dream Zoo and Zynga City on Tencent. Zynga mentioned that poker bookings fell due to illegitimate card activity on the Internet, a user shift to mobile platform and to more casual casino activities such as slots. This demonstrates the volatile nature of social gaming as even a game like poker isn’t finding it easy to hold on to the users. Clearly, Zynga needs a fundamental shift in its core business.

Disappointing Update On Real Money Gaming Success

Last quarter Zynga rolled out real-money games ZyngaPlusPoker and ZyngaPlusCasino in the U.K. and was looking into getting a license in the U.S. for the same. Q2 was disappointing on this front as the company did not give material insight into the initial traction of these games in the U.K. and announced that it will not purse the license for online gambling in the U.S. In addition to this, it stated that its recent acquisition of Spooky Cool Labs, which is involved in building social and online gambling games, was motivated by its intention to leverage Spooky Cool Labs‘ assets and capabilities to promote social slots, not real money gaming. We believe that Zynga should not lose focus on tapping international online gambling market, as the opportunity is big and could help it reduce the dependence on volatile free social games.

According to the management of Betable, a gambling platform, the online gambling market outside the U.S. is worth more than $32 billion. [2] Gambling research group H2 Gambling Capital estimates that the global online gambling market stood at 21.73 billion euros or 19 billion pounds in 2012. [3] The research firm further expects this market to grow by 30% over the next three years. While Zynga has already launched in Europe, it may want to expand to China later on. China’s online gambling market is expected to grow close to $12 billion in 2013. This may not be surprising as Macau, which is a special administrative region of China, is already the biggest casino market in the world.

Zynga can make a big difference to its business if it can tap this market successfully. It appears that the global online gambling market could reach $40-45 billion in the next five years, and even if Zynga can grab 1-2% share of this market, it could add additional $400-$900 million in revenues. This translates into an upside of about 20-30% to our price estimate. However, the company will have to deal with competition from gaming incumbents such as Caesars Entertainment, which already operates online gambling services in Europe and has bought social and mobile game maker Playtika.

What Next?

We believe that Zynga will focus on expanding mid-core games and will adopt a steady approach of building up user base rather than relying on explosive and unsustainable growth as it has seen in the past. The company launched some mid-core games on mobile this quarter including War of the Fallen, Battlestone and Solstice‬ Arena. Such games have a different growth trajectory and tend to build audience over longer periods of time. In addition, the company’s long term strategy of creating its own gaming ecosystem will protect it against the inherent volatility of individual social gaming titles. What Zynga needs is better games, innovation, more sustainable ways of monetizing games as well as higher focus on core gamers. New CEO Don Mattrick can leverage his vast experience in building sustainable customer base for Xbox Live to offer fresh perspective and help the company in managing its costs better.

We are in the process of updating our price estimate for Zynga in the light of recent earnings, and will have an update ready soon.

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Notes:
  1. Zynga’s Q2 2013 Earnings Transcript [] [] []
  2. Big Fish Casino Raises The Stakes On iPhone With Real-Money Gambling, TechCrunch, Aug 16 2012 []
  3. Probability looks at U.S. alliances as online gambling gathers steam, Reuters, Apr 18 2013 []