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Is Zynga Going to Go Belly-Up?


The outlook for the social-gaming company is worrying.


While it might be a little bit premature to start calling for the demise of social-gaming company Zynga (ZNGA) (after all it only came public in December 2011), one might reconsider after looking at the stock chart.

The company's IPO was priced at $10.00 and the stock traded over $14.00 as recently as this March -- as Facebook (FB) was preparing its much-hyped IPO. Subsequently, the stock has been decimated, falling to the $5.00 level earlier this week.

After an extremely disappointing earnings report, which was released on Wednesday after the market close, shares have fallen another 40 percent to just above $3.00. The company reported a second-quarter net loss of $22.81 million or $0.03 per share, versus net income of $1.39 million or breakeven per share, in the year ago period.

Adjusted net income, which is comparable to analyst's consensus, was just $4.56 million or $0.01 per share, compared to $38.17 million or $0.05 per share, in last year's second-quarter. This badly missed Wall Street analysts' consensus EPS estimates of $0.06.

Total revenues in the quarter were up 19 percent to $332.49 million versus $279.14 million last year. This also missed Wall Street consensus estimates of $344.12 million by a wide margin. In the quarter, daily active users increased 23 percent to 72 million from last year's corresponding period and monthly active users rose by 34 percent to 306 million. The company held seven of the top ten games on Facebook, including popular titles Znyga Poker, FarmVille and CityVille.

While Znyga was able to show decent top-line and user growth, with advertising revenue more than doubling, it wasn't enough to meet investor expectations. Making matters much worse, the company drastically lowered its fiscal 2012 outlook. The company now sees a range between $0.04-0.09 per share, compared to previous guidance of $0.23-0.29.

Currently, analysts' are expecting Zynga to earn $0.27 per share in fiscal 2012. The company cited delays in new games, a faster decline in existing web games due in part to a more challenging environment on the Facebook platform, and reduced expectations for Draw Something for the guidance cut.

The severely reduced expectations are likely to cause Wall Street to completely lose faith in Zynga's management. A number of brokers downgraded the stock immediately. Furthermore, this stock now looks much more expensive. At $5.00, prior to Thursday's plunge, and with the Street expecting 2012 EPS of $0.27, the stock was trading at around 18.5X this year's earnings expectations. Given the company's revenue growth metrics, this seemed like a reasonable valuation.

In light of the updated guidance, however, the $5.00 price now seems exorbitant and the current price of around $3.20 may also be high. Using the top-end of the company's updated EPS guidance, $0.09, at $5.00 the stock would be trading at around 55.5x this year's earnings - and the company only grew revenue by 19 percent in the quarter. If we use the low-end of the guidance, $0.04, then Zynga would be trading at 125x this year's earnings.

Even after the plunge, this stock still looks expensive. At $3.20, the stock is trading at 35.5x the company's high-end EPS guidance for 2012 and 80x the low-end. Before today's report, Wall Street analysts were projecting that Zynga would earn $0.36 per share on revenues of $1.74 billion in fiscal 2013. Needless to say, these figures go out the window after today.

Maybe the worst part about all of this is that Zynga's management allowed it to happen. Wall Street guidance is largely shaped by discussions with management. After this debacle, how long will it take for Zynga's management to regain the confidence and trust of investors and analysts? Furthermore, Yahoo Finance detailed how Zynga insiders cashed out of the stock before the massive plunge which occurred over the last few months.

In April, Zynga conducted a "secondary stock offering" in which insiders dumped 43 million shares of stock at $12 a share, raking in about $516 million. Nice timing. The article notes that the insiders "cashed out in the same quarter in which Znyga imploded." All of the stock was sold by insiders and none of the proceeds went to the company. The biggest beneficiary of this secondary offering was none other than Zynga CEO Mark Pincus, who made $200 million.

The author of the article, BusinessInsider's Henry Blodget, notes that he knows many of the people involved in the secondary offering and that "I think the last thing they would intentionally do is unload stock when they thought it was about to crash." He also notes that most of the sellers in the offering still have large Zynga stakes, so the dramatic sell-off has hurt them too. Nevertheless, the optics are horrible -- and the timing, regardless of what Mr. Blodget's personal opinion is, appears very suspicious.

Even at current prices, Zynga still has a market cap of roughly $2.25 billion. The asset is still worth a considerable amount of money, but one has to wonder if the business isn't doomed. There are two immediate questions that investors should ask themselves. First, how stable is Zynga's business model? The answer has to be, "not very." The company makes Facebook games. It is inextricably tied to the future of Facebook, which frankly, shouldn't incite tremendous confidence.

Also, the gaming market is very fickle and disparate. At one time, games like checkers and Monopoly were popular. The entire sector is extremely competitive and consumers have an array of platforms to choose from. A shift in consumer preferences can happen in no time at all. Zynga had better be incredibly nimble and at the evolutionary cutting-edge or it might not last.

Furthermore, what effect will the current problems at the company have on its top talent? If its top people start leaving, this company could go down in a hurry. Surely, competitors will be looking to pick-off embittered Zynga employees who are seeing the value of their stock options plummet. If Zynga sees an outflow of top talent, the company could see its valuation plummet below $1 billion by this time next year.

This New York Times article outlines the toxic working atmosphere at the company. The title, "Zynga's Tough Culture Risks a Talent Drain," is ominous in light of current developments. How many creative, Silicon Valley types are going to want to stick around in an environment which one source described as being "very similar to a New York investment bank," when the rewards and excitement of success no longer exist?

Editor's Note: This content was originally published on by Scott Rubin.

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