February 19, 2012 7:12 pm

Revenues test reality of Zynga’s empire building

Analysts last week questioned whether Zynga could reach the “Dream Heights” suggested by its latest title, whose launch coincided with the first earnings report of the leading social games publisher as a public company.

The game, challenging players to build a skyscraper up to 50 stories , is reminiscent of an image in Zynga’s investor roadshow in December representing its vision. A skyscraper-high Zynga stands shoulder to shoulder with towers for Google, Amazon and Facebook – alluding to the largest social games publisher by players joining the online giants of search, shopping and social networks.

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Such dreamy heights seem fanciful indeed based on reported fourth-quarter revenues of $311m, up less than 1 per cent compared with the third. That kind of growth puts Zynga’s empire-building still at foundations level, while its forward price/earnings ratio of 50 times is the only thing threatening the stratosphere.

Zynga’s results were broadly within Wall Street expectations of $301m in sales and 3 cents a share in profits – it made 5 cents.

“Zynga’s first quarter out of the box was about in line, but given its valuation, we don’t think in line is enough to make the stock work,” said analysts at Macquarie Capital. “It needed to show a significant top-line beat.”

The zing went out of Zynga’s shares on Wednesday, the day after results, falling nearly 18 per cent to $11.81. The shares have not yet recovered, closing on Friday at $12.93, compared with its pre-earnings peak of $14.55 on Valentine’s day.

However, Zynga’s stock is still trading higher than its $10 IPO price in December 2011, priced at the top of the range, and shares had been rallying beforehand. Investors were apparently in love with Zynga due to its close relationship with Facebook, which announced its own IPO plan on February 1.

Facebook’s filing showed the size of Zynga’s contribution to revenues – the money it spent on advertising and the 30 per cent cut Facebook took from Zynga’s sales of virtual goods amounted to 12 per cent of Facebook’s revenues in 2011, or $445m – its biggest single source of income.

Zynga has the top five games on Facebook in CityVille, Texas HoldEm Poker, Hidden Chronicles, CastleVille and FarmVille.

It has 247m monthly active users, according to appdata.com, more than five times those of its rival Electronic Arts.

But analysts like Doug Creutz at Cowen and Company say that Zynga’s Facebook business is not growing fast enough and its mobile games – a focus for expansion – still have a relatively small part of a very competitive market.

“So why would you want to pay 50 to 60 times earnings for a content company that competes in a low barrier for entry business?”

That compares with Electronic Arts’ 15 times for the year ending March 2013.

“It’s not Google, Apple or Facebook, it’s a games company and it doesn’t own a platform,” he says.

But while other analysts reduced their expectations, Wedbush Securities raised its price target from $14 to $17. It is encouraged by strong growth in mobile users, the possibilities for global expansion and the quality and differentiation of games being released.

Michael Pachter, Wedbush video game analyst, says Zynga initially disappointed with vague promises of growth in the back half of 2012 and no details on the games that could be expected. “They made a ton of rookie mistakes and the biggest one was not being transparent – why would it hurt to name the games coming out?” he says.

“I’m bullish because I think they have a lot of growth in front of them.”

His optimism was matched by Mark Pincus, Zynga founder and chief executive, who pointed to the forecast by In-Stat, the research firm, for growth in global virtual-goods sales to $15bn by 2014 from $9bn in 2011. “We believe that the majority of that growth will be in the west and that Zynga will continue to lead that market,” he said.

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