A look inside Zynga’s numbers

Originally, I was not going to post about Zynga’s earnings report, which was released Wednesday evening. I am not a stock analyst and I did not feel I brought much to the party. However, the announcement caused so much conversation both from companies in the social gaming space and pretty much everyone else, that I felt remiss if I did not add my analysis.

What the numbers really say
The most important numbers are that Zynga generated $302 million in bookings (an alternative measurement of revenue that is more accurate for social game companies other than GAAP revenue) and a loss of $22.8 milion for the quarter. For the year, Zynga is projecting revenue of about $1.2 billion and a profit (adjusted EBITDA) of between $180 million and $250 million.

These numbers are all below analysts’ and investors’ expectations, and prompted Zynga’s stock to drop almost 40 percent. If you read the press or blogs (or talked to people at Casual Connect), you would think this 40 percent drop meant either the end of the social gaming industry, the end of Facebook, or at least the end of Zynga. What it reflects, however, were the huge expectations for Zynga leading up to its IPO. Zynga would have had to continue its miraculous growth to justify its initial public valuation, and quite simply, it did not. That does not make Zynga a bad company or social gaming a dying industry; it just means everyone must face reality.

Comparison with Glu
An interesting juxtaposition was Zynga’s fortunes compared with Glu Mobile’s earnings report last week. Glu beat analysts’ estimates on both revenue and profits. Glu reported revenue for the quarter of $21.6 million, with a $6 million loss for the quarter. Because these numbers exceeded expectations, Glu’s shares jumped and analysts spoke as if it showed that they were a hotter company than Zynga. The bottom line is Zynga generated almost 14 times the revenue of Glu (almost $280 million more) and has multiple Facebook games that generate more revenue individually than Glu does as a company.

I do not wish to imply that I am beating up on Glu; I have some good friends there (hopefully still after this post) and they are on the right track. I just feel it is quite important to highlight and compare the absolute numbers that both these companies are generating, because many people are creating a narrative that does not fit the facts and then making decisions based on this narrative. Since Glu is one of the few publicly traded mobile game companies that generates most of its revenue outside Asia, it is a good starting point to gather data to compare with Zynga. Glu was in the mobile space before Zynga even existed. Although it was slow to move to free-to-play, it had a huge head start on most gaming companies in the mobile social gaming sphere. If mobile was truly the money machine so many would like us to believe and Facebook was a dead platform, shouldn’t Glu be closer to Zynga in revenue rather than 1/14th its size? From these numbers, we can probably extrapolate the revenue of other mobile-only social gaming companies. And those numbers are almost certainly not close to Zynga’s (again, excluding the Asian social mobile companies).

So why did Zynga miss its numbers?
One of the most interesting elements of the earnings call was the reasons that Zynga missed its numbers. According to Mark Pincus, “[Zynga] saw declines in engagement and bookings for our Web games due in part to changes Facebook made to their platform.” Zynga also blamed the lower earnings on delayed product launches and reduced expectations for Draw Something.

The above is the “official” line. In my analysis there are three real reasons that Zynga underperformed

1. We exist in a hit-driven industry. I previously wrote that at best 25 percent of social games break even or make a profit. Zynga is not immune to these baseline rates. As much as social and mobile game companies have tried to convince VCs and investors that we no longer live in a hit-driven world, the reality is we do and Zynga does (as does EA, Disney, etc.). Thus, every launch has a 75 percent chance of failure and that is what Zynga experienced last quarter. They did not lose their magic; they suffered regression to the mean. If they had one hit last quarter (or have one this quarter), the narrative will be entirely different, even though the underlying business remains unchanged.
2. Fast following is not as easy at is used to be. There was a day when Zynga could identify a successful game on Facebook, polish the underlying mechanic and theme, and blow up their product with overwhelming marketing. The market has evolved to the point that this strategy no longer works. While Zynga was able to overwhelm SocialApps (MyFarm) with the launch of Farmville, Mob Wars’ creator David Maestri with Mafia Wars and Playdom (Social City) with Cityville, using this model, the new wave of competitors are not as easy picking. Playdom is now owned by Disney, so Zynga’s attempt to overwhelm Gardens of Time was met dollar for dollar. The launch of Ville was disappointing because Zynga was now competing for players with EA, who could drive as much traffic as it wanted to The Sims Social.Even NimbleBit (Tiny Tower) was able to stave off Dream Heights because in the current social gaming environment, it could acquire enough users that there were few left for Zynga. This last point is particularly relevant, as once a game gains broad popularity (e.g., The Sims Social or Tiny Tower) it is virtually impossible to win over that audience unless you make a revolutionary improvement to the experience. Once a player has invested time and money into a game, they are not going to switch to another game (and lose that investment) just because the interface is a little cleaner or graphics sharper.

   I witnessed the same thing when launching international versions of popular Facebook games as a separate product. Even though people preferred to play in their native language, it was not worth it to switch to the localized version for most players and lose the progress they had made in the English version (in many cases dooming the branched versions). The same dynamic now limits Zynga’s ability to win over existing players from popular competing social games by introducing a mildly better version (and because of marketing, there are very few users who have not been exposed to the original).

3. When you burn the furniture, you have nothing to sit on. I have worked at several ventures that were nearing an exit event and in all my experiences extraordinary efforts were made to move revenue and profits into the period that would most impact valuation, even if it hurt future business. In one case, I was asked to “burn the furniture” so more revenue could be recognized in the month we were hoping to close a deal, even at the expense of negatively impacting revenue for quarters to come. Although I have no direct knowledge of how Zynga operated just before its IPO, given the mentality I have seen frequently, it is not a big stretch to think a lot of furniture was burned pre-IPO that now has to be replaced (and thus dragging on revenue and profitability).

What the numbers do not mean
First, mobile has not replaced Facebook web as the only social platform. Although Zynga listed Facebook as its number one problem, its mobile performance has been no better (let’s not forget that Words with Friends, Draw Something and Dream Tower were first and foremost mobile offerings). Moreover, as I pointed out by comparing Zynga’s performance with Glu’s, Zynga is still generating more from individual Facebook games than Glu is generating as a company, despite Glu’s focus and experience in the mobile space. I am not saying mobile social is not a great opportunity or potentially the future of our industry (or a key part of it);  but we must look at the facts before writing off the Facebook platform.

Second, Zynga is far from dead. I do not have an opinion on Zynga’s valuation, but just looking at the numbers I recapped above ($300+ million in bookings for the quarter, $1.2 billion in revenue projected for the year and an expected annual profit of over $180 million) shows that Zynga is one of the most important game companies in the world and clearly the leading social game company outside of Asia.

Shut up Zynga haters
The main reason for this post is to counter some of the incredibly stupid comments I have seen in the last few days both from inside and outside the industry.

The glee that our colleagues in the social game space are taking at Zynga’s difficulties are not logical and will hurt them as much as anyone. Like it or not, outside of our little world, social gaming and Zynga are virtually synonymous. Thus, if people feel Zynga is not a good company, they feel we are not in a good industry. That leads to fewer investment dollars and fewer opportunities for an exit (either through an acquisition or public offering). If they are already part of a larger public company, it means their importance to the parent company is diminished, because the multiple applied to their revenue is less. With lower importance, comes less investment (e.g., fewer resources and potentially less staff). It is cute to laugh at Zynga until you hear that your group is being closed down because social gaming is no longer attractive.

Even more annoying are the sometimes incredibly ignorant comments from industry analysts who really do not understand our industry. These type of comments have always been a problem in the game space, as we have a very idiosyncratic industry that is difficult to understand from the outside. Add to that problem that because the gaming space is small in absolute terms, we typically do not receive attention from the “AAA” analysts.

The most absurd comment I saw in this round of commentary about Zynga was from Michael Gartenberg, who said, “At the end of the day, though, virtual goods might not be a viable business strategy. People eventually stop spending money in virtual goods and want to spend that money on real goods.” Yet Gartenberg provided no evidence that this is the case (keep in mind that Zynga’s revenue was effectively flat), other than apparently wishful thinking on his part. The same week that Zynga missed its numbers, Starbucks also significantly missed theirs (and also suffered a big hit on its stock). I am surprised that Gartenberg did not comment on this situation that “At the end of the day, though, premium coffee might not be a viable business strategy. People eventually stop spending $4 on coffee and want to spend only $0.50 on real coffee.”

Conclusion
I do not know if Zynga’s stock is overpriced or underpriced, but I wrote this post in the hopes that people can look objectively at the company and industry rather than get sucked into a highly inaccurate narrative.

Author: Lloyd Melnick

I am GM of Chumba at VGW, where I lead the Chumba Casino team. Previously, I was Director of StarsPlay, the social gaming vertical for the Stars Group. I was also Sr Dir at Zynga's social casino (including Hit It Rich! slots, Zynga Poker and our mobile games), where I led VIP CRM efforts and arranged licensing deals. I have been a central part of the senior management team (CCO, GM and CGO) at three exits (Merscom/Playdom, Playdom/Disney and Spooky Cool/Zynga) worth over $700 million. View all posts by Lloyd Melnick