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.

Watch Out for These Red Flags at Zynga Inc (ZNGA)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.

Earnings from media giant sustained euphoria

Investors assumed that the rosy quarter Facebook Inc (NASDAQ:FB) reported would mean better times ahead for Zynga, too. But Facebook Inc (NASDAQ:FB) is de-emphasizing the importance of games in its social network, in favor of rapidly growing revenue from advertising and search. As its games become harder to find on Facebook Inc (NASDAQ:FB), Zynga Inc (NASDAQ:ZNGA)’s user activity will dwindle, diminishing its chances to make money off its gaming audience.

OMGPOP staff cut

Zynga surprised the market when it decided it was shutting down the OMGPOP studio, maker of the successful gameDraw Something, as part of a 520-employee layoff. The cut will save Zynga $80 million, but also reduce the company’s overall value. Zynga paid $180 million only a year ago.

Zynga Inc (NASDAQ:ZNGA) is admitting that not only was the OMGPOP acquisition a big mistake, but Zynga’s fickle user base is shrinking so quickly that Zynga does not think the unit will be profitable.

For instance,Draw Something 2had astrongstart as the No. 1 download on iOS within two days of its release, when the game was released on April 25, 2013. By early May, the game dropped to number 31 spot. The Android version of the game was released in May, has 466 reviews and a 3.5 star rating. The low statistics suggests that the game will not likely grow in popularity on the Android.

Foolish Bottom Line

Speculative investors will look at the sharp drop in Zynga as a chance to load up, but the social networking channels that were once available to grow its user base are shrinking. Real-money online gambling could still interest bulls. Zynga launched gambling services in the UK in April, but its partner,, made only $32 million in profits in 2012.

Online gambling will have little impact on Zynga’s bottom line, and will not be meaningful until the service is offered in the U.S. — a prospect that faces numerous delays. This will only mean a lower share price for Zynga Inc (NASDAQ:ZNGA) in the short term.

Chris Lau has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard, Inc. (NASDAQ:ATVI) and Facebook Inc (NASDAQ:FB). The Motley Fool owns shares of Activision Blizzard and Facebook.

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