Last month, Zynga, the social gaming firm, purchased the latest fad in the social gaming sphere OMGPOP, for $200 million which represents 18% of Zynga’s 2011 sales. The acquisition added 20.5 million daily active users (DAU) ($9.76 per user) and $91 million in revenue. Based on recent trends, it appears that Zynga purchased the company at peak performance. Since the acquisition OMGPOP’s primary game ‘Draw Something’ has fallen from number one to anywhere from second to twelfth on the iPhone and between sixth and eight on the iPad. During the writing of this thesis I learned that the declines are accelerating - http://www.businessinsider.com/chart-of-the-day-daily-users-of-draw-something-totally-crater-2012-4?nr_email_referer=1&utm_source=Triggermail&utm_medium=email&utm_term=SAI%20Chart%20Of%20The%20Day&utm_campaign=SAI_COTD_041612

Because of acquisitions like OMGPOP, I like to think of Zynga as an oil company. It has a large collection of assets (games) that are either growing through new discovery or depleting due to use. Although as the OMGPOP acquisition shows, digital assets can deplete much more rapidly than an oil field.

Thesis
Zynga made the OMGPOP acquisition because its core business has either stabilized or is in decline. For example, in the first quarter, daily active users were flat. And, OMGPOP’s revenue per DAU is ~$0.01 versus Zynga’s $0.06 so profitability is likely to suffer.

The typical path for a Zynga game is a buildup in daily active users over a 1-3 month period followed by a gradual decline. The reason for this dynamic is that video games regardless of the context become boring to the user after a period of time. Currently, the only thing keeping Zynga’s DAU steady is recent launches. The older games are losing DAU at an accelerating pace. For example, games that are older than six months were -30% in Q1 of 2012 versus that the same category losing only 23% in Q3 of 2011.

Key Industry Dynamic
To say Zynga is in a hit driven business is an understatement. The game OMGPOP game ‘Draw Something’ reached 50 million downloads in just a few short months. And this success was achieved with 40 employees, a $17 million investment and very little in the way of marketing expenditures. OMGPOP’s incredible performance will no doubt attract thousands of copycats who could easily become the next fad and take meaningful share from Zynga’s business.

As there clearly are no barriers to entry, I think it is accurate to describe almost a favorable downward ramp for competitors to enter the industry (the opposite of one of Porter’s five forces). Companies like Zynga drove industry wide DAU growth in past years, but the winner of the DAU battle is fought every day in the top 20-50 DAU rankings gamers use to find games. It would be like Chevron discovering a large oil field but having to compete every day to have control of the drilling rigs.

And, to say social games have a network effect is another understatement. Much like the Angry Birds game, social games have a slingshot dynamic that are massively destructive to the structure of the industry. Once a game builds momentum growth generally accelerates (like long lines at a night club). Likewise, once users realize a game is losing popularity, the declines get larger. Also, as previously mentioned, the cost to build a game (i.e. pulling back the sling shot) is very low. In the VC world, funding a $5-10 million game is like a cheap call option, so I would anticipate serious competition to Zynga over time.

Strength of the Business
When analyzing the competitive advantages of a company, I prefer to separate the analysis into a resource based view and a capabilities analysis.

Resource Based View
The one key asset the company has is the ability to cross market games through the use of banner ads in existing games. The cross marketing helps existing users transition onto new games. However, this dynamic does not help Zynga acquire new users. And banner ads are no guarantee the existing user base will not migrate away from the platform altogether. As mentioned before, the most effective advertisement is rapid user growth (shown via the game rankings) and no company can control that.
Further, the resource’s value depends entirely on accessing a large pool of DAU the company does not control. And, it appears that the DAU switching costs actually turn into switching benefits over time (how is that for customer loyalty).

Capabilities Analysis
Zynga has a strong management team. They wisely issued stock at a very high price in previous months. And, the company does have a design team with a successful track record for building hit games. However, Zynga’s lead game designer left the company in March to join a competitor. And, game development talent does not appear to be unique (nor loyal) based on the many other small social gaming companies that manage to achieve spectacular success.

Other Paths to Growth?
Given that the total DAU is stable, it is clear that the growth of new game launches is coming at the expense of older games. And it is safe to assume that the number of social gamers has reached a stabilized level of growth (how many people have time or would want to play Castleville?)
The primary way Zynga can still grow ex-acquisitions is by growing revenue per DAU. But, Zynga’s games are already designed to extract as much revenue from core players as possible.
Furthermore, Zynga’s user base is becoming more diverse. As a result, the revenue per DAU is trending lower. It seems likely that most of the hard core users who pay have already discovered Zynga and hold up the existing revenue base. And as the company attempts to grow through mobile, margins will decline even further because revenue per user from mobile is meaningfully less than through Facebook based games.

Existing Competition
In terms of competition it is hard to know where to begin an assessment because the threats come from so many directions. Electronic Arts (EA) is quickly growing in the social gaming sphere. Because of EA’s size, resources and capabilities, it is a serious threat to Zynga in an industry that is increasingly becoming a zero sum game. Rovio (Angry Birds) is a smaller but equally dangerous competitor to Zynga. Currently, it is one big reason OMGPOP is falling in the rankings. And to accomplish this feat, all Rovio had to do was to launch a new version of the existing game Angry Birds.

Supplier Concentration and How Facebook Controls the Key Asset In the Social Gaming Industry
Facebook takes a 30% cut for any revenue generated on its site through Zynga. The contract expires in 2015. Obviously several years from now but this contract expiration does add risk to the perpetuity value (lower exit multiple). First, Zynga’s games are heavily dependent on Facebook. There are many copycat versions of Zynga games and were Zynga to leave the site, their games would be at a meaningful disadvantage because all things being equal, users prefer to be connected with their friends while they play. And, Zynga’s attempt to use mobile and/or its own website is not going well. Third, by 2015, Facebook will be much less dependent on Zynga due to significant growth in mobile gaming publishing. So it is possible Facebook could take an even larger share from Zynga. Facebook owns the key resource in the relationship (the large social network). Making games is, in contrast, a commodity.

Zynga’s Gambling Gamble
Zynga is currently in talks with Wynn to potentially break into the online gambling market. First, even if online gambling is legalized, it will probably be done so on a state by state basis. The localized process will make the many launches very costly for a company like Zynga to compete because it has no experience in gambling regulation. Furthermore, Wynn only has a license in Las Vegas so the rollout would still be slow.

The bigger problem for Zynga is the reputational risk. From a PR perspective, the tragic stories connected to gambling are like mud on a pig to a gambling company. But if stories get out in the media about Zynga’s gambling games being connected to terrible tragedies, its image could suffer with its existing user base. At a minimum, it makes it harder for Zynga to his its primary asset (gaming sphere with cross marketing) to build DAU growth. I do not think Zynga wants to be responsible for a large number of new gambling addicts. Potential news headline: “From Farmville to Gambling Addiction, Zynga’s Impact on Users”

Other Risks
My analysis assumes social gaming continues to grow over years. It is possible a larger percentage of the current users become less enthusiastic about the games. Because the inflow rate is now stabilized at a relatively low level, acceleration in the outflow will drain the DAU inventory. Console games, for example, have experienced some decline. If the DAU pie stops growing, competition in the industry will become even more intense.

Also, there will be a meaningful amount of insider selling as the free float will increase by 700% by August due to lockups expiring.

Valuation and Conclusion
Zynga is clearly in a very bad industry. Not only does it not have meaningful barriers to entry, its activities have made it easier for smaller competitors to enter. Yet, the company trades at 20x 2012 EV/EBITDA estimates. Companies in bad industries with stagnant growth typically trade between 3-6x EV/EBITDA. I will use the top to give the short seller a margin of safety (target of ~$3.60 and assumes the cash is needed inventory for rapid fire acquisitions but clearly that is a positive and part of the reason why I used a 6x and not a 4x or 5x).

Zynga also deserves a low EV/EBITDA multiple because it has a very high level of CAPEX. For the last three years, Zynga’s CAPEX has been at 21% of sales (21% in 2011). Given it is very likely they will be required to make OMGPOP type acquisitions every few years (I will assume every three years although three years in the social media gaming space is like 15 years in a normal industry) their real CAPEX to sales ratio is 27%. EA (trading at 6x forward EV/EBITDA) averages only 4%. So as Warren Buffet likes to say, because the tooth fairy doesn’t pay for CAPEX, it is a good idea to adjust EV/EBITDA multiples for CAPEX levels. But I will leave that in the margin of safety for the short seller. I personally would not buy this stock above $2 given the extreme operating volatility.

I can already hear the Zynga bulls screaming that the $3.60 price target is outrageous. Valuing a company with $150 million in free cash flow at $2.6 billion is actually generous and allows room for growth. It only appears to be outrageous in the context of a ridiculous social media bubble that investment banks are once again fueling (remember the 90s?) to maximize fees.

Companies in bad industries should get low multiples regardless of hype. Once the hype fades, the stock will fall towards fair value. Look at the chart for Pandora or Demand Media. Zynga will follow that pattern because the economics of its business are highly unattractive and its core business is no longer growing.
Disclosure: I am short Zynga.