Zynga's Recipe for Disaster: IPO Contains Sudden-Death Scenario
Zynga admits in its IPO disclosures that most of its users don't generate any revenue for the company, and "a small number of games" account for a majority of its $235 million in Q1 2011 revenue.
The disclosures aren't unusual -- on the web, many businesses only convert a minority of their visitors into customers. But Zynga's business model makes the company unusually vulnerable to a small number of failures that could, in a worst-case scenario, collapse the company.
Here's what the company says about its users, most of whom cost the company money because they play for free and don't buy virtual goods:
A small percentage of our players account for nearly all of our revenue. We lose paying players in the ordinary course of business. In order to sustain our revenue levels, we must attract new paying players or increase the amount our players pay. To retain paying players, we must devote significant resources so that the games they play retain their interest and attract them to our other games.So far, so good. This is looking like that common business phenomenon the Pareto principle, or the rule that says 80 percent of your revenues comes from 20 percent of your customers.
But then Zynga warns that this "small percentage" isn't spread evenly throughout its games. Most of its games, it appears, never generate significant revenues:
Historically we have depended on a small number of games for a majority of our revenue and we expect that this dependency will continue for the foreseeable future.So this is a business dependent on a small number of users in a small number of games for a majority of its health. And Zynga's health fluctuates. "Daily Average Users" peaked at 67 million in Q1 2010, then declined to 48 million in Q4 2010, and went back up to 62 million in Q1 2011. Clearly, players can get bored quickly and leave, unless Zynga works hard to tempt them back.
All work and no play
Recently, Zynga has been working harder. It spent more on new game development to earn its revenues. Those R&D expenses are eating into its profits: R&D spend increased by $43.9 million to $72 million in Q1 2011 from the prior year, mostly due to hiring and rewarding game-creating talent. (To put that in perspective, the company's net income in Q1 2011 was only $12 million.)
In 2010, R&D expenses were $149 million. In 2009, they were just $51 million. R&D used to be as little as 23 percent of the company's revenues in 2010, now it's 30 percent (click to enlarge):
Zynga warns that if this spending doesn't pay off, "our business will suffer":
If we are unable to successfully expand the platforms and devices on which our games are available, or if the versions of our games that we create for alternative platforms and devices are not compelling to our players, our business will suffer.Zynga's weird accounting methods
So Zynga is dependent on a small percentage of its customers, who have a demonstrated history of getting bored easily, and the company cannot easily replace its blockbuster hits, as it did FarmVille with CityVille. The company further warns that the popularity of its games is threatened by virtual inflation (if Zynga prices its in-game goods and tokens incorrectly); unauthorized third-party token sellers; and cheat programs that play the game for unscrupulous users.
Simply put, while Zynga currently has a profitable business on its hands, that business is fickle and is structured in such a way that when it tanks it is could do so suddenly, rather than in a long, slow decline. A handful of misfiring new games could do it. Unfortunately, Zynga's finances could disguise the swiftness of its decline. Zynga amortizes its revenue rather than booking it immediately when sales are made:
We record the sale of virtual goods as deferred revenue and then recognize that revenue over the estimated average life of the purchased virtual goods or as the virtual goods are consumed.This means Zynga's current revenues are higher than represented on its income statement because a portion of them are being spread out across future periods. Right now, there is $516 million in "deferred revenues" sitting on Zynga's balance sheet. This, the company's disclosures imply, is cash that the company has already taken from customers but has yet to be declared as revenue. As long as Zynga takes in new customers this will not be a problem. But if Zynga starts to lose customers the speed of its decline will be disguised by all that deferred revenue appearing on future income statements, even though the sales that generated that revenue were made long ago. Put simply, if disaster strikes, the scale of the problem might not be obvious to investors until it's too late.
Life imitates art at Zynga, too: The company also warned that because it is based in San Francisco it may not survive an earthquake:
Our facilities are located near known earthquake fault zones, and the occurrence of an earthquake or other natural disaster could cause damage to our facilities and equipment, which could require us to curtail or cease operations.Related: