Can Zynga bounce back?

Posted on July 29, 2013 by Eric Benjamin Seufert

Zynga

Zynga’s Q2 earnings filing was abysmal: the company reported that its bookings – a non-GAAP accounting convention that recognizes revenue at the time of a transaction – decreased by 38% year-over-year, its DAU decreased year-over-year by nearly 50% to 39MM, and its Monthy Unique Payers (MUPs) decreased by 53% year-over-year.

Zynga is clearly in turnaround mode, having hired a new CEO in Don Mattrick three weeks ago in a move that transitioned former CEO and founder Mark Pincus into the Chief Product Officer role (it’s worth noting that Pincus remains chairman and still controls more than 60% of the company’s voting rights). But even despite the new blood and Facebook’s strong quarterly results (which are relevant to Zynga, given that 68% of its revenue is generated on the social network), Zynga’s stock price plummeted on Friday following its earnings release. Can the company bounce back?

The strategic mis-steps that guided Zynga to its current position are popularly recognized as some combination of:

  • Mistaking its privileged position on the Facebook platform as a permanent competitive advantage, delaying the point at which it made a genuine transition to mobile;
  • Ballooning its headcount to an unsustainable level during the frothy days of Facebook’s platform growth in Western markets;
  • Limiting its product portfolio to casual titles that could only be profitably marketed through a viral subsidy provided by  Facebook in the form of news feed spam.

But now that Zynga finds itself in the position it was forced to articulate in its Q2 earnings filing – declining DAUs, declining bookings, and a proportion of mobile revenues that is dwarfed by the industry standard – what does it plan to do to reverse the situation? Its earnings call with analysts revealed some interesting clues.

In the call, Don Mattrick outlined steps that Zynga has already taken that he believes will improve its profitability and top-line growth going forward:

  • In early June, Zynga laid off 520 employees — approximately 18% of its staff – bringing its total headcount to around 2,300 at the end of the quarter. Natural attrition brought the total net decrease in headcount for the quarter to 628.
  • Zynga announced in the call that it will not pursue a real money gambling license in the US and will instead focus on social casual casino titles, believing the opportunity in that vertical to be more valuable. In late June, Zynga acquired Spooky Cool Labs, a studio with deep expertise in social casual casino gaming. Some analysts expressed skepticism over the decision, believing Zynga’s advantaged position in real-money gambling was the greatest point of optimism with respect to the company’s future.
  • Shifting its focus to midcore games, having launched War of the Fallen, Battlestone, and Solstice Arena in April, May, and June, respectively. According to Mattrick, Zynga believes its expansion into midcore titles will help revive its flagging monetization metrics and stem its DAU decline.
  • Increased attention on Zynga’s second-largest franchise, Zynga Poker, which experienced a decrease in bookings for the second quarter owing to an increase in illegitimate transactions on the web.

Mattrick also pointed out that the unprecedented level of platform growth across Facebook, Apple, and Google should improve Zynga’s standing by default – a “rising tide lifts all boats” argument that seemingly fell flat with the analysts on the call.

Whether or not the strategy formed by the above points will help revive Zynga remains to be seen, but one thing is for certain: Zynga has abundant coffers from which the strategy can be financed. Zynga lists $1.245BN in current assets on its balance sheet, including over $1BN in cash and marketable securities (highly liquid securities that can quickly be converted to cash).

In Q2, Zynga’s loss before income taxes was $33.794MM – meaning that if nothing about its business changes (revenue and expenses stay the same), with its current assets on hand, it could theoretically (and this is admittedly an oversimplification) fund operations for 36 more quarters. That is an incredible amount of time over which to execute a turnaround strategy.

Zynga also seemingly initiated an earnest initiative to reign in expenses in Q2, reducing its cash expenditures by $22MM (through a combination of layoffs and decreased technology spending), although its decrease in R&D spending by 18% year-over-year may not bode well for competing in mobile, where games are increasingly tech-driven.

In the call, Zynga advised bookings for Q3 of between $125-150MM, down from $188MM in Q2, with projected GAAP revenue for the quarter of $175-200MM. The difference between bookings and GAAP revenue here is somewhat significant: by GAAP standards, Zynga must account for its revenue over the lifetime of the virtual goods it sells, meaning GAAP-based revenue will be higher than bookings in a protracted state of decline (because current-quarter revenue is benefiting from sales made in previous quarters). The fact that Zynga identifies the spread between GAAP-based revenue and bookings as between $50 and $75MM – or 27% and 40% of Q2 bookings – doesn’t inspire confidence.

One elucidating point in the post-earnings report Q&A with analysts came when John Egbert of Morgan Stanley asked David Ko, Zynga’s COO, if, given Zynga’s increased focus on mobile, a mobile version of FarmVille 2 is currently being developed. Ko dithered and evaded the question – which seemed odd, given that Mattrick had, less than 20 minutes earlier, been espousing a grand vision for the company that had mobile at its focal point.

Another telling moment came when Richard Greenfield of BTIG asked Mattrick if Zynga should further cull its headcount, given that its rival King – the developer behind Candy Crush Saga – only employs around 400 people. Mattrick responded that he sees Zynga’s current headcount as a source of leverage opportunity, implying that no further reductions in workforce are currently planned.

Whether Zynga can reverse course fast enough to retain the best of its ranks remains to be seen: Zynga experienced an exodus of top executives in 2012 and early 2013, including its Chief Game Designer, Brian Reynolds. But given the depths that Zynga’s stock has reached since its IPO, even the smallest sign that a new strategy is working could inspire upward pressure on its stock price – especially since Zynga has one of the lowest Enterprise Value to Sales ratios in its industry given perpetual investor pessimism about the company. The potential for such a stock increase could be enough of an impetus to convince key employees to stay put.

Whatever course Zynga takes over the next 12 months, it can’t be said that the company doesn’t have the resources to execute on it zealously. The questions that persist are whether the company can hold onto key talent for long enough for its strategy to bear fruit and whether too much ground has been lost on the mobile front to realistically compete.