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Where Zynga Went Wrong

It's official: The business is stalling, and Zynga's prospects don't look good. Here's what happened.
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When Zynga announced its earnings, the news was not what Wall Street wanted to hear. Profits had dropped to a penny a share, or one-sixth of what analysts expected. Investors reacted, and not in a good way, as Zynga stock slid nearly 40%.

And it may slide a lot more before things are done. At one time, Zynga seemed on top of the world. Even though the company didn't seem to need money, CEO Mark Pincus tried to capitalize on the thirst for Internet companies by taking the company public and creating a structure that gave himself most of the control. But in the process of scaling up and believing in his own vision, he forgot how a business based on fads and fickle consumer tastes can get into trouble very quickly.

Riding a Fad

In some industries--food, housing, energy--you know that even with fluctuations, your customers need some basic level of service. In others, what you provide is optional, and customers can turn away when times are tough. Entertainment and travel are two sectors that can get hit hard.

But then there are companies that play on what are essentially fads. Clothing and consumer electronics can fall into that category. So can online services. Even a company like Wham-O, which has ridden entertainment fads for more than 50 years and owns such icons as Frisbee, Hula Hoop, and Slip 'N Slide, can find the business limiting in the long run: The company has an estimated $12.3 million in annual revenue, according to business intelligence site Hoover's. In these industries, entrepreneurs can ride a wave of success and suddenly find it falling away when consumers decide they're bored and head off to do something else.

That has been happening to Zynga. Even though the company said that daily active users hit 72 million last quarter, up from 59 million the year before, the number counts the acquisition of OMGPop and its Draw Something users. According to Sterne Agee analyst Arvind Bhatia, four games were responsible for 72% of Zynga's Q1 revenue. Traffic on those games is dropping, as the Sterne Agee graph below shows:

Fewer users doesn't necessarily mean lower revenue. It all depends on which users you lose. Zynga is losing the wrong ones.

Too Much Dependency on Too Few Users

Zynga noted that Facebook users didn't spend as much as they once did. This is the essential problem of a so-called freemium business model, in which everyone gets some amount of free services and a tiny portion pays for additional services. The small portion of users that pay brings in most of the revenue.

In Zynga's case, the quarter that ended in June saw a total of $322.5 million in revenue. Of that, 12.3% came from advertising and 87.7% was from the sale of virtual goods. That includes the OMGPop business. Compare it with the previous quarter, when the acquisition was not yet officially part of the mix. Total revenue was $321 million, with $292.8 million, or 91.2%, from user purchases and the remaining 8.8% was advertising.

Zynga is finding that user fatigue can set in, so that area of revenue is flat. Maybe people are getting tired of the same games, or perhaps this is just a secondary effect of a broader economic malaise. Whatever the reason, it translates into a potentially limiting pressure on the business.

Trying to Correct the Uncontrollable

Entrepreneurs, even when experienced, can often make a near-fatal mistake of assuming that they can pull out of anything that goes wrong. Pincus is trying to take steps to halt the problems. For example, the Draw Something acquisition was supposed to do just that. However, according to Sterne Agee, that user base is also on a rapid decline.

The $180 million that Pincus paid for OMGPop may not have brought in the financial benefits his company badly needed.

Zynga has tried to create its own gaming networks. Unfortunately for the company, by far most of its revenue still comes from Facebook. Whatever happens on the social networking giant can, as a result, have a heavy impact on Zynga. Company management blamed changes that Facebook made to making it more difficult for users to find games. Zynga heavily advertises its games and then, as you know if you've ever played any of its titles, keeps trying to push users into drawing in their friends.

It's a heavy-handed marketing approach that begins to smack of desperation. Zynga might have been able to succeed in a more sustained way on a smaller basis by focusing on core customers and revenue diversification from the beginning. As it is, according to Bhatia, the company's major hope may be "the potential for legalization of online gambling next year." And that's quite a gamble for any entrepreneur to take.

Last updated: Jul 26, 2012

ERIK SHERMAN | Columnist

Erik Sherman's work has appeared in such publications as The Wall Street Journal, The New York Times Magazine, and Fortune. He also blogs for CBS MoneyWatch.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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