Red Flags at Zynga Inc (ZNGA)

The market’s euphoria for social networking companies is not completely over. Investors took new interest in Zynga Inc (NASDAQ:ZNGA) when the company showed promise for growth from gambling and demonstrated strong performance in mobile titles. The general rise in stock markets helped, too. Then, reality set in, when the company cut OMGPOP loose. The announced cost cuts at Zynga would be more substantial than anyone thought. Now that the cost cuts have pushed shares down 15%, is it time for investors who bet on a successful turnaround to give up?

Hope built up … then dashed

Two recent events gave investors hope that Zynga Inc (NASDAQ:ZNGA) could improve its operations. A first-quarter earnings result that beat consensus estimates fueled investors’ confidence that the company’s turnaround was firmly in place. Zynga reduced costs everywhere possible, slashing sales and marketing costs by 52%, and general and administrative costs by 41%.

But while cost cuts can often signal a company’s return to profitability, they were a red flag for Zynga.

The company slashed research and development by 31%. Zynga Inc (NASDAQ:ZNGA) made the cuts because the strategy of developing numerous game titles in hopes of making a popular hit was not working.

Reducing the number of titles and R&D costs will likely have the opposite effect of raising risks for Zynga, since the company is relying on fewer titles for more of its success. These remaining titles produced may not end up as major hits, and this will disappoint investors.

Electronic Arts Inc. (NASDAQ:EA) and Activision Blizzard, Inc. (NASDAQ:ATVI) also reduced their title counts over the last few years. The difference is that these game companies have hit titles that are already recognizable. For Electronic Arts Inc. (NASDAQ:EA), Battlefield and FIFA are guaranteed hits. For Activision Blizzard, Inc. (NASDAQ:ATVI), the Call of Duty series has a big installed base. These companies have a large marketing budget to ensure their success, something missicng for Zynga.

ZNGA data by YCharts

Another red flag in Zynga Inc (NASDAQ:ZNGA)’s quarterly report was the 21% year-over-year decline in daily active users (“DAUs”), to 52 million.