Zynga (and analysts with “Buy” recommendations on Zynga stock) have been very publicly positive about the company’s defensive acquisition strategy. The OMGPOP deal has been much-discussed (not lease because of questions of professional conduct following the takeover), but with the dust settled, Zynga has been noisy about the search for other targets. Doubtless, Zynga has deep pockets, with c.$1.8bn cash available and ample opportunity to take on debt and bankroll potentially expensive takeovers. Acquisitions (even of the c.$200m valuation of OMGPOP) are within budget. But will they provide Zynga with the market share stability hoped for?
I’m not convinced. In fact, were I a shareholder, I would be concerned at the M&A-centric approach being taken in an immature and fragmented market with low barriers to entry. Zynga need to make a better strategic case to shareholders that the acquisitions fit within a considered portfolio, because social/mobile casual gaming is not a market suited to defensive, scatter-gun buying of big names.
Zynga’s price has spent the last few weeks drifting down from c.$13 to $10 (where it sits today), and I believe it still has a way to go.
What Zynga is doing:
Zynga, as the primary partner with Facebook, has a strong position in the online, casual gaming space. However, revenues are mainly supported by in-game advertising (only 2.9m monthly users, or less than 2% of total players pay cash for virtual goods), and the company is strongly reliant on the terms of its agreement with Facebook. I have argued before that this position is not inherently risky – the relationship is symbiotic, and Facebook are not looking to drive Zynga out of business. However, games companies with well-established franchises (having realised that the development costs for social, casual games are low, while IRRs are high), such as EA and Activision Blizzard, are moving quickly into the space, and Facebook is ambivalent as to which companies provide its games, provided that user-interest is high.
Zynga (as I have discussed in previous posts) is under pressure to de-risk, by developing non-Facebook products and expanding beyond the casual online space into mobile. This makes sense, insofar as diversity of products limits Zynga exposure to the whims of Facebook (although, as discussed previously, I believe that market participants are understating the symbiotic nature of this partnership).
The Zynga capital structure, following the IPO, makes an acquisition strategy an obvious choice. The company is cash-overweight, with c.$1.8bn to draw on, and no debt on the books. However, Zynga have adopted a very particular approach to acquisitions: purchase newly-established “big” franchises, and hope to capture as much of the current market by doing so.
The OMGPOP deal is a perfect example of this strategy. OMGPOP, best known for Draw Something, was bought at the end of March for an undisclosed sum (probably c.$200m). The valuation seems to have been entirely based on the success of Draw Something, which is not to be taken lightly, with revenues estimated at c.$250,000 daily. But even with those present-day revenues, any sensible estimation of user-attrition and a conservative view of OMGPOP’s pipeline (the company has c.25 other games that have not been international bestsellers – success is not guaranteed) leaves the valuation looking a little high.
One can only assume that Zynga factored one of two assumptions (or both) into their view of the buy:
- OMGPOP is likely to produce successful games in the future.
- Other companies are not likely to draw (sorry) Draw Something’s users away with competitive products.
My intuition is that both assumptions are false, that “Draw Something”-levels of adoption are very rare, and that the market has low barriers to entry, with competitive products arriving quickly and confidently.
The strategy isn’t sustainable, and will not create shareholder value:
Clearly Zynga is excellently positioned in the social gaming market, dominating Facebook. In looking to de-risk, and diversify away from Facebook, it will likely look to acquire other developers with IPO-generated cash. But hunting down the “big names” and winning them over with Pincus’ promises of entrepreneurial working relationships doesn’t make commercial sense.
The mobile gaming marketplace as a whole is geared for growth, with improved mobile internet infrastructure arriving alongside graphically more capable handsets. However, the market is highly fragmented, churns titles quickly and has unusually low development barriers to entry (mobile games are much cheaper to develop than AAA console titles). Some longer-standing games companies (such as EA, Activision Blizzard, Ubisoft and THQ) bring established franchises over from other platforms and have some economic moats from which to release mobile products. However, even these forms of competitive advantage count for less in the mobile space. Gamer behaviours are different from other formats, and games need not be complex or even complete to be hits. The success of new titles is simply very difficult to predict.
Zynga are placing bets on historical performance as a guide to future success when they pay for “single title” houses like OMGPOP. To buy at the height of Draw Something’s popularity leverages that bet harder – in that exposure to the success of the “single title” is ruled out by high acquisition costs. Zynga have not made it clear to the market (I believe because there may well be little underlying rationale) how the OMGPOP assets beyond Draw Something will create value for shareholders.
The mobile gaming market is likely to be dominated by “hits”, and franchises like Angry Birds (Rovio) illustrate the point. But the nature of the market makes the prediction of the next hit very difficult, with smaller development teams with little experience being completely capable of putting out market-changing products.
Zynga has reached out to buy other “hit” franchises, with Rovio and PopCap reporting approaches (both declined Zynga offers), suggesting that the “buy big” strategy is a real ambition. If the company succeeds in overpaying for another OMGPOP, shareholder returns will continue to be negatively affected.
The bottom line:
Unless Zynga can find a development strategy that leads to their acquiring developers that fit within a considered portfolio, shareholder returns will not be enhanced by takeovers. Simply buying up competitors and “single title” houses, despite the deep pockets that the Zynga capital structure affords, is not a sustainable growth strategy in such a rapidly changing market.
Expect to see the share price fall further than its current $10 level.