Zynga's Slow Growth Is Trouble for Social Games

It's been just two months since it went public, yet some of the luster has already came off social game company Zynga (Nasdaq: ZNGA). Last Wednesday, its shares lost nearly 18% of value from Tuesday's all-time high close after the company released its first earnings report. The tumble came even though Zynga clocked in with non-GAAP earnings of $0.05 per share for the fourth quarter, beating earnings estimates of $0.03 per share.

Zynga churns out a slew of social games that include Words with Friends, FarmVille, and Hidden Chronicles, which players can access -- and invite their friends to play along -- through platforms such as Facebook and on mobile devices. Zynga reported a net loss of $404.3 million on revenue of $1.1 billion for year ended December 31, 2011, which included $510 million in stock-based compensation for employees triggered by its December IPO. In addition to the employee compensation, Zynga said it invested more heavily on research to develop new games. That compares with profits of $90.6 million on $597.5 million in revenue for the prior year.

Shares plunged to close at $11.80 on Wednesday, down from Tuesday's $14.35 close. Zynga's shares recovered somewhat on Thursday and Friday, and are trading for slightly more than $13 today. But Arvind Bhatia, senior research analyst with Sterne Agee, believes there are questions the company has not fully addressed. "We think the top line growth slowed quite a bit," he said.

Bhatia said the traffic of daily active users of Zynga's games did not grow much in the fourth quarter compared with the third quarter. He also said Zynga changed the way it grouped the number people playing its games. "Companies only change this if the numbers don't look good," he said.

Bhatia explained that Zynga lumped together users who paid about $1 to play Zynga games with those who paid $10. That metric may show an overall increase it total number of users, but Bhatia says it does not give a clear picture of the audience's willingness to pay to play. "Any company that does that doesn't deserve the kind of multiple they are getting on the market," Bhatia said.

Zynga is reportedly making an effort to expand its roster of games to attract more players. David Wehner, Zynga's CFO, said during the earnings call that last year the company put more cash into developing expansions as well as new titles to keep its pipeline full. "About a third of R&D spending was invested games that had not yet launched by the end of 2011," Wehner said, adding that Zynga also invested in other technology infrastructure improvements.

Though development costs are expected to increase for young companies, Bhatia said growth must scale up as well. With Zynga's margins under pressure, such costs become an issue. "This would be less relevant if growth was there," he said. In its earnings report, Zynga said it expects slow growth in the first half of 2012 with more gains projected for the latter part of the year. Bhatia saw that as a red flag and questioned what would fuel such an escalation. "It makes you more skeptical," he said.

While Zynga is not the only social game company on the scene, it is the biggest player. Much of its gains relate to the rise of Facebook. As more people joined that social network, they also started to play games Zynga offers on the platform. Zynga said it is working on ways to grow without complete attachment to the hip of Facebook. Regardless, Bhatia says there may be signs the public is a little weary of killing time with this type of electronic distraction. "There is a little bit of exhaustion in social games," he said.